Traditional IRA & Roth IRA: What’s the difference?

March 10th, 2015 Cindy Mays

How are you preparing for your future? Are you climbing the ladder at work? Taking classes to learn new skills?  What about building a nest egg for your finances?

One way to prepare for your future is to place your money into an Individual Retirement Account (IRA). An IRA is, in essence, a savings account for your retirement that comes with beneficial tax breaks .

According to a 2014 report from Investment Company Institute, nearly 41.5 million households owned at least one type of IRA in the United States. The two most common IRAs are the Traditional IRA and the Roth IRA. Each offers distinct advantages for your financial goals and situation.

Before we see the differences of the two retirement accounts, let’s look at how they are similar. The Traditional IRA and Roth IRA have contribution limits of $5,500, or $6,500 if you’re age 50 ½ or older. The deadline for your contributions is your tax return filing date (not including extensions). In 2015, you have until April 15 to make your 2014 contributions.

Now, let’s see how each IRA is different.

Contribution limits

With a traditional IRA, you can make contributions to it as long as you have earned income. However, your tax deductibility is based on income limits and participation in an employer plan.

You can contribute to a Roth IRA if your tax-filing status is, “single,” and you have a modified adjusted gross income (AGI) of less than $129,000. If your status is, “married filing jointly,” you must have an AGI of less than $191,000. You can contribute if you are, “married filing separately,” if one of you has an AGI of $10,000 or less.

These limits can change, annually. You can see the limits here.

Tax treatment

In a traditional IRA, your contributions are tax deductible in your federal and state tax returns for the year you make a contribution. You will pay taxes on the withdrawals you make during your retirement.

In a Roth IRA, contributions can be withdrawn penalty-free and tax-free any time. Typically, you must hold the Roth IRA for five years and be 59 ½ before you access the earnings. You will pay taxes on the front-end of the account, meaning you will pay no taxes when you make withdrawals.

Rules for withdrawals

With a traditional IRA, withdrawals are tax-free and penalty-free beginning at age 59 ½. Distributions, or the minimum amount you must withdraw from the IRA, must begin by age 70 ½. If you leave an IRA for your beneficiaries, they will pay taxes on the inheritance. If you are under age 59 ½, you may withdraw up to $10,000, without the normal 10 percent penalty for early withdrawals, to pay for a qualified first-time homebuyer expense. You will still pay taxes on the distribution.

After five years and age 59 ½, all withdrawals from your Roth IRA are required during the account holder’s lifetime. Beneficiaries are allowed to stretch the distributions over many years. Up to $10,000 can be withdrawn penalty-free, to cover first-time homebuyer expenses. Unlike the traditional IRA, you do not have to pay taxes on distributions when you withdraw money from this account.

Taxes on distributions and withdrawals

Any deductible contributions and earnings you withdraw or distribute from a traditional IRA are taxable. You may have to pay an extra 10 percent tax for early withdrawals if you are under age 59 ½.

You will not be taxed on qualified distributions, or withdrawals that qualify as a distribution, with a Roth IRA. Distributions or withdrawals which do not qualify may be taxed. Similar to above, you may have to pay an extra 10 percent tax for early withdrawals under age 59 ½.

IRAs are great tools for creating a little assurance, later in life. Our MidWestOne bankers will help you find the option that makes sense for you. Contact your local MidWestOne banker or call us at 800-247-4418 to learn more.

Cindy Mays

About the author

Cindy Mays is Market President at MidWestOne Bank. She works in the retail department, specializing in checking and savings accounts, auto loans and home equity loans.

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