Roth IRA versus Traditional IRA: Which is Better?

People who want to invest money for their retirement face a major decision regarding which type of IRA account to open — Roth IRA or Traditional IRA. Both types of IRAs have their advantages and disadvantages. So, the answer isn't a clear winner. But, the information below may help you decide which may be a suitable choice for your particular situation.

Tax Benefits

The biggest benefit of a Roth IRA is that it offers tax-free growth of your investments. With a Roth IRA, you will never pay taxes on withdrawals of your contributions. Also, you won't pay taxes on withdrawals of your earnings as long as you take them after you have reached age 59½ and owned the account for at least 5 years. In short, you fund the Roth IRA with your post-tax dollars (i.e. no tax deduction) and, in return, the government gives you the benefit of the tax-free growth of your contributions.

Reverse is true for the Traditional IRA. Traditional IRA offers tax-deferred growth of your investments. With a Traditional IRA, you fund your account with your pre-tax dollar (i.e. take tax deduction on your tax return). Your investments will grow tax-deferred until you retire. When you retire, you will pay ordinary income tax on withdrawals of all earnings and on any contributions you originally deducted on your taxes.

Income Limits

Now, there are some caveats and fine prints. For a Roth IRA, your contribution limit phases out at the Modified Adjusted Gross Income (known as MAGI) of $112,000 if you file as single head of the household or married filing separately AND at $178,000 if you file as married filing jointly or as a qualifying widower. See this chart from the IRS.

For a Traditional IRA, contribution limit and tax deduction depends on whether you or your spouse are covered by a retirement plan such as 401(K) plan at work.

If you or your spouse are covered by a retirement plan plan at work, then your tax deductions will phase out at $59,000 if you file as single head of the household AND at $95,000 if you file your taxes married filing jointly or as a qualified widower. For more info on the effect of MAGI on deduction of Traditional IRA contributions, see this chart from IRS.

For a Traditional IRA, if you or your spouse are NOT covered by a retirement plan at work, then there are no income limits if you file your taxes as a single head of the household or as married filing jointly or separately where none of you are covered by a retirement plan at work.

The deduction starts to phase out at MAGI of $178,000 if you file as married filing joint or separately and one of the spouses is covered by a retirement plan at work. See this chart from the IRS.

Age Eligibility

You can contribute to a Roth IRA at any age. In case of to the Traditional IRA, you must be under the age of 70½ to contribute.

Withdrawals

Another major benefit of a Roth IRA is that you are NOT forced to withdraw your savings during your lifetime. You can even leave this money to your heirs when you die. With a Traditional IRA, you will need to take the required minimum distributions (RMDs) starting at the age 70½.

Contribution Amount Limits

You can contribute a maximum of $5,500 ($6,500 if you are 50 or older) or 100% of employment compensation, whichever is less in 2013 or in 2014.

Penalties

For a Roth IRA, there are no penalties on withdrawals of your contributions if you held the account for 5 years. There is a 10% federal penalty tax on withdrawals of earnings before you reach the age 59½.

For a Traditional IRA, there is 10% federal penalty tax on withdrawals of both the contributions and earnings before you reach the age 59½.

But, you can escape that 10% tax penalty if you're withdrawing the money for a few specific reasons for either of the IRAs. These include:

• Paying college expenses for you, your spouse, your children or grandchildren.
• Paying medical expenses greater than 7.5% of your adjusted gross income.
• Paying for a first-time home purchase (up to $10,000).
• Paying for the costs of a sudden disability.

Be sure to check with the IRS guidelines on what will and will not qualify.

Discussion on which IRA is better

Deciding on which IRA is better or worse depends on a lot of factors including your current age, your current income, your future earnings potential, and your current tax situation.

Many experts believe that income taxes will rise in the coming decades for nearly everybody to support the national debt as well as social security and medicare programs. There is also another school of thought that says instead of raising income taxes, government will phase out or eliminate some of the tax deductions.

Given this information, if you are a young person at an early stage of a career and aren't in a higher tax bracket now but will be when you become experienced, then you would benefit from a Roth IRA. You will lose out on the tax deductions in the short-term, but in return, you will pay NO taxes in later years when you retire.

If you are in your prime earning years now and are in a higher income tax bracket, then you may want to consider investing in a Traditional IRA account. You will benefit from lower taxes now with the tax deductions. And, when you retire, you will pay taxes on your contributions and earnings. But, it may be likely that you may fall into a lower-income tax bracket as you would not be earning full salary.

Since projecting the future is always uncertain, you can hedge your bets and open both types of IRAs for yourself or between you and your spouse. In my own case, I have a Roth IRA for me and a Traditional IRA for my wife. Tax deduction lowers our taxes now with the Traditional IRA account and in the future Roth IRA will give you the security of tax-free withdrawals.

I personally don't know which way income taxes are headed and what will be our income situation when we retire. But, I feel comfortable with this choice.

Lastly, if you are confused, are on the fence, or don't know what to do, go with the default choice of a Roth IRA. Don't delay the decision to contribute because the longer you hold your funds, the longer time it will have for your investments to compound. Your compounded returns will more than offset the tax savings later down the road. The key thing is to get started NOW. Leave the rest to the economy.