Q: How do traditional & Roth IRAs differ?

A: While they share the same last name and many characteristics, there are also some distinct differences between these two kinds of tax-advantaged accounts, and those differences are critical in determining which, if either, is right for you.

Probably the most important difference between traditional and Roth IRAs is the way they offer their tax advantages. As with most things governed by IRS rules, there are lots of if’s, and’s, or but’s that affect the practical application, and it would be far too ambitious to try to cover them all here. But at its simplest level, the difference between the two is when you pay the income tax on your money.

The original concept was that you would fund a traditional IRA with pre-tax money, let the money grow tax-deferred during your working years, and pay income taxes later when you withdraw the money, usually in retirement when you are presumably in a lower tax bracket. (Some of you may recognize this as similar to the way your 401k works.) Not a bad deal, eh? The problem comes in that not everyone qualifies to deduct their traditional IRA, as there are income and other limits, so some taxpayers lose a portion of the benefit of traditional IRAs. (For example, in 2005, for a couple married filing jointly, deductibility starts to phase out when Adjusted Gross Income hits $70,000 if both have access to an employer-sponsored retirement plan.)

Another important factor that comes into play is that, per traditional IRA laws, taxpayers have to take Required Minimum Distributions (RMDs), and pay taxes on them, starting at age 70 1/2;, even if they don’t need the money. It turns out that not all taxpayers are in a lower bracket in retirement, so some people find that they end up with a pretty hefty tax bill once RMD time comes around.

With a Roth IRA, you make your contributions with money you’ve already paid income taxes on, but you owe no taxes prior to or upon withdrawal. Sounds like a fairly minor difference but it has fairly major implications. For starters, there are no RMDs, so you choose whether to take withdrawals or continue to let the money grow tax-deferred. In fact, if it turns out you do such a good job saving that you never need the money, your Roth can even produce tax-free income for your heirs well into the future. For those who anticipate higher tax rates in the future, saving to a Roth is a great way to hedge against that risk.

Another nice feature of the Roth is that, unlike traditional IRAs, if you continue to have earned income and you don’t need the money for living expenses or whatever, you can make contributions past age 70 1/2;, assuming you are eligible. Unfortunately, not everyone is eligible to take advantage of Roth IRAs, as there are income limits. (For example, in 2005, for a couple married filing jointly, Roth eligibility begins to phase out when Adjusted Gross Income reaches $150,000.) However, the unique characteristics of the Roth IRA make it a very powerful planning tool, for the reasons listed here and many more, and those who qualify should definitely consider making a Roth IRA part of their financial plan.

NOTE: There are many more traditional and Roth IRA facts, features, qualifications, limits, etc., than this article covers. To learn more, try visiting the TurboTax Web site, which has several good IRA articles written in plain English. The very detail-oriented might also want to venture onto the IRS Web site.