Roth vs. Traditional IRA

In recent days I've heard many commercials on the radio that discuss the differences between the Roth IRA and the Traditional IRA. These commercials are spot on regarding the facts, but the question most people have is which IRA is best for them.

In making a decision it is best to know something about how each IRA works.

A traditional IRA allows most taxpayers to contribute up to $4,000 each year. If you are not a part of an employer plan such as a 401(k) you are generally allowed to take a tax deduction for the amount that you contribute. The money placed in the account will not be subject to tax until the taxpayer begins to withdraw money at some point in the future. If you pull the money out after age 59 1/2 you will include the distribution in your ordinary income and pay taxes on it. If the money is withdrawn before age 59 1/2 and you meet none of the exceptions you pay not only the ordinary tax on the amount taken, but a 10% penalty on top of that.

A Roth IRA is different in that you do not receive a deduction for the amount that is placed into the plan, however the amounts placed in the plan grow tax free and you do not have to pay any tax on amounts taken out after 59 1/2. The Roth does allow a person an opportunity to get the money before 59 1/2 tax free if the funds are used for the first time purchase of a home, education expenses and a few other exceptions.

Either IRA is includible in Estate Tax calculations, however the person who receives the proceeds of a Traditional IRA will pay ordinary taxes on that amount whereas they would receive a Roth IRA without that burden.

So which one works best?

A good rule of thumb is to consider the tax bracket you are in. If you are in the 15% or less tax bracket it makes sense to go with the Roth IRA. Why? If you contribute $4,000 to the plan you would save $600 in taxes right now based on your tax bracket. That's a nice savings, but I'd rather have the money grow tax free over several years and have the money taken out tax free under the Roth plan. You may also consider that it might be likely that you would be in a higher tax bracket in the future and therefore not paying any taxes on your Roth IRA provides more tax savings for you.

The next thing I would look at is age. In my opinion, the younger you are the more likely I think it will be that you should use a Roth IRA. I believe this because the more years your money grows tax free the more tax savings you have. If you are under 40 years old a Roth IRA is probably your best option because you will have 20+ years of tax free growth before you need to access the money.

A traditional IRA is best used if you are in a higher tax bracket because the amount saved with the contribution is greater at the outset. A person in the 35% bracket who makes a $4,000 contribution immediately saves $1,400 in taxes. This translates to a 35% return on investment in year one.

The other issue is that if one makes over $110,000 it is unlikely they can contribute to a Roth IRA and the Traditional IRA becomes the best option by default.

In any event you should speak to your CPA to determine which one is right for you.