Friday, July 17, 2009

What is the Difference Between a Traditional IRA and a Roth IRA?

The biggest difference between a traditional IRA and a Roth IRA is when the assets are taxed. While the traditional IRA provides an upfront tax deduction and tax deferral on an investment’s growth, a Roth IRA does not provide an initial tax deduction but the assets grow tax-FREE.

Which investment vehicle is superior for a particular investor is often a function of whether an individual expects to be in a higher tax bracket now or during retirement. If an investor expects to be in a lower tax bracket during retirement, it would likely be most favorable to use a traditional IRA to defer taxes until the individual can take advantage of a lower tax rate. However, if the investor anticipates being in the same or a higher tax bracket during retirement, it may be a good strategy to pay taxes on the assets now and enjoy tax free growth going forward.

Roth IRAs offer additional benefits. First, because the assets have already been taxed, Roth IRAs pass to an investor’s beneficiaries tax-free. Moreover, because the federal government lacks the ability to tax Roth accounts, it does not require investors to take required minimum distributions (RMDs) from these accounts. Consequently, Roth assets can take full advantage of their tax-free growth. Finally, investors can contribute to a Roth IRA regardless of whether or not they are an active participant in a qualified employer-sponsored retirement plan. However, married couples filing jointly must have an AGI of less than $166k in order to make contributions to a Roth IRA.

Roth IRAs have the ability to accept “converted IRA” funds. A traditional IRA, SEP, or Simple IRA can be converted to a Roth IRA if an investor’s modified adjusted gross income is less than $100,000. Converted funds are taxed as ordinary income, but enjoy tax-free growth going forward. In 2010, all investors, regardless of their MAGI, will have the ability to convert other retirement accounts to Roth IRA accounts. All investors should speak to a financial planner to decide whether a Roth conversion is appropriate for their situation.

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