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TRADITIONAL
IRA vs. ROTH IRA
What's
the difference?
There are actually 11
different types of IRA's but the two
we hear about most often are the traditional IRA and
the Roth IRA. Well, what's the difference???
The
Traditional IRA
The tax breaks for a traditional IRA are of the "this
is tax-deductible" kind. That means that the money
you deposit in your IRA isn't taxed in the year you
deposited. And regardless, whatever earnings you have
on your contributions, you won't be taxed until you
withdraw that money many years later.
For
example, let's say you made $30,000 during the year,
and you put $2,000 of it into an traditional IRA. You
would pay income tax on only $28,000. Additionally,
your deposit will grow free of tax through the years.
When you finally withdraw the money for your retirement
after the age of 59 1/2. Then, and only then, will the
money you withdraw be taxed as income at your ordinary
income tax rate (which in many cases will be less than
what it might have been when you deposited it).
If
you withdraw the funds before age 59 1/2, then in most
cases you'll have to pay both income tax and a 10% penalty
on whatever earnings have accrued -- but if the funds
are used to pay for "qualified higher education
expenses" or for one of the other eight exceptions
to the 10% early withdrawal penalty, then the penalty
will be waived.
Remember
that you can put just about anything you want in an
IRA account. Under the onslaught of marketing from banks,
you may have come to the conclusion that an IRA is somehow
connected to a CD (certificate of deposit). This is
because that is what most banks sell. But be advised,
you are not limited
to what the banks offer. If you're a
smart and savvy investor then you'll maximize your IRA...
maybe by buying real estate or funding a private
mortgage!
The
Roth IRA
The tax breaks for a Roth IRA are different. Unlike
a contribution to a traditional IRA, a Roth IRA contribution
is never deductible. Taking the above example, you'd
still be taxed on $30,000 even though you had put the
same $2,000 into a Roth IRA. However, when you withdraw
the money from a Roth IRA, none of it -- and that includes
the earnings -- will be taxed, assuming that the Roth
IRA has been open for at least five tax-years and you
are older than age 59 1/2. That's right -- you get off
scot-free with the booty. All you have to do is to wait
until you can withdraw it penalty-free. Again, that's
after age 59 1/2, and as long as it's been in there
for at least five years.
In
other words, the
Roth offers tax-exempt rather than simply tax-deferred
savings. One word makes a big difference. While both
allow you to accumulate wealth without paying taxes
along the way on your profits, the traditional IRA ultimately
sticks you with a tax bill for those profits (plus your
initial contributions if those were deducted when made).
The Roth doesn't. As long as you follow the rules, you
never pay taxes on your gains. So paying the piper now
before contributing to the Roth may work out to be better
for you than paying him later on your investment profits.
This is why, in my opinion, the Roth IRA is too powerful
and too valuable to pass up... especially if you plan
to use a self-directed Roth IRA to buy real
estate or private mortgages.
Please feel free to contact us by clicking
here now or simply call us at 1-877-752-5601.
The
Roth makes particular sense for people otherwise limited
to making non-deductible contributions to a regular
IRA. And the Roth is fully available to single filers
making up to $95,000 and couples making up to $150,000.
It also allows you great flexibility by allowing you,
in many cases, to withdraw your principal contributions
at any time tax-free, without penalty. First-time home-buyers
can also pull out $10,000 in profits penalty free and
tax-free, provided that the money has been in the Roth
IRA for at least five tax years. There are also some
breaks for education spending, though an Education IRA
may be a better vehicle for education savings (but a
CESA might be even better). Barring these exceptions,
though, profits withdrawn before retirement age and
before the money has been in the Roth for at least five
tax-years will be taxed, plus you'll also incur a 10%
penalty when those earnings are taken before age 59
1/2.
To
Convert or Not to Convert
Because the Roth is potentially better than the traditional
IRA, it may make sense for you to convert a current
traditional IRA into a Roth. To do so, you will have
to pay taxes on your old IRA, but there will be no penalty
for early withdrawal. Is this a smart thing to do? The
answer depends on your income tax rate today versus
that in retirement; how you will pay the income tax
bill due on the conversion; how long the Roth IRA will
remain untouched; and the size of the IRA coupled with
your desires for your estate. In general, if you have
to use your IRA savings to pay taxes triggered by shifting
them to a Roth, then you may be sacrificing too much
principal up-front to make the deal worthwhile, unless
you have many years to make up for this dip into your
savings. You should also note that funds rolled over
into a Roth IRA come under greater restrictions for
penalty-free and tax-free distributions as compared
to normal Roth IRA contributions.
DISCLAIMER:
WN Funding or its affiliates hold
no licenses for financial planning and WN Funding is
not a registered security with the Securities &
Exchange Commission.
None of the information on this website should be
viewed as tax or legal advice. Please be sure to consult
your attorney, accountant, and/or other licensed professional
needed before considering any investment or conversion.
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