By: Ahsan Bashir,

Traditional vs ROTH IRA

Opening and contributing towards an Individual Retirement Account or an IRA is one of the most important decision, an individual makes for his/her financial future. An IRA is an account or an arrangement that allows you to contribute a certain Dollar amount either Tax free or Tax Deferred annually for a future financial benefit upon retirement. There are limits each year, on the maximum amount an individual can contribute towards an IRA account. For Tax year 2008, the limit for an Individual is $5000.00. If you file a Married filing Joint return, the total amount is $10,000.00, i.e $5000.00 for each. There are two types of IRA's, both with different Tax implications.

(a) Traditional IRA

Traditional IRA
If you choose the traditional IRA, you save on tax upfront. The amount you contribute towards the Traditional IRA account, you do not pay the tax on the contribution. That amount is subtracted form your taxable Income for the current Tax year in which you contribute, and therefore you pay less in taxes. However, you pay the tax on earnings when you withdraw from the account. The withdrawals can start at age 59 1/2 and are mandatory at age 70 1/2. If you choose to withdraw funds before age 59 1/2, there is a 10% penalty on the amount withdrawn. There are no Income Restrictions for the Traditional IRA regardless of your earnings. These funds can be used to purchase a variety of Investments including stocks, bonds, certificates of deposits, etc.

Contributions towards a ROTH IRA are not tax deductible upfront and there is no Mandatory distribution age like the Traditional IRA. However, the earnings and distributions are 100% tax free if rules and regulations are followed. Like the traditional IRA, the funds can be used to purchase stocks, bonds, certificates of deposits, etc. The principal contributions can be withdrawn at any time without any penalty, subject to some minimal conditions. The benefit is limited to single filers with a maximum Income of $95000.00 annually and married couples making a combined Income of $150,000 annually.

The biggest difference between the Roth and Traditional IRA is being Tax Deductible and Tax Free, and the age restrictions for the withdrawal of the traditional IRA. There are, however, 8 exemptions to avoid the 10%  withdrawal penalty on the traditional IRA.

1. Permanent disability of IRA owner

Money can be withdrawn without penalty in the event the IRA holder becomes permanently disabled.

2. Death of IRA owner

It's small consolation, but if you kick-the-bucket before you're 59 1/2 years old, your estate won't be hit with the 10% early withdrawal fee.

3. Withdrawals are used to pay non-reimbursed medical expenses

In the event of serious illness or injury that requires prolonged or expensive medical treatment, Uncle Sam will waive the early withdrawal fee on the condition that the expenses are in excess of 7.5% of your adjusted gross income.

4. Withdrawals used to help pay for first-time home purchase

Despite a lifetime limit of $10,000, this exemption can make it much easier for an IRA owner to buy a house.

5. Higher education costs

College can be expensive. Thankfully, certain higher education costs for you, your spouse, children or grandchildren can be withdrawn penalty-free. You may still owe federal income tax, however. For more information, read the Internal Revenue Service article, Notice 97-60 Using IRA Withdrawals To Pay Higher Education Expenses.

6. Money is used to pay back taxes to the IRS after a levy has been placed against the IRA

This is not the kind of exemption for which you want to qualify, but it may save you money if you find yourself in an uncomfortable position with the IRS.

7. Withdrawals used to pay medical insurance premiums

Out of a job? The rest of the world may be topsy-turvy, but rest assured, you won't be penalized for using retirement money to pay your medical insurance as long as you have been on unemployment for longer than twelve weeks.

8. Made on or after the day the IRA owner turns 59 1/2

Once you have reached the qualifying age of 59 1/2, you can make penalty-free regular withdrawals upon which to live. 

IRA's of both types can be opened through a bank or brokerage house. If you are interested in holding stocks or bonds in your IRA, it may be wiser to open an account with your broker. It should require no more than a few minutes' visit to the local branch office, or a trip to their website.

Posted 3:02 AM

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