Compare the Two Types of IRAs

When you hear the word “IRA,” what comes to mind? There are two basic types: the traditional IRA and the Roth IRA. It is important to know the similarities and distinctions.

For starters, the annual limit for contributions to all IRAs for the 2012 tax year, in any combination, is $5,000 (increasing to $5,500 in 2013). Plus, you can add an additional $1,000 if you are age 50 or older. There is no current tax on the contributions earnings in any account. You still have until April 15, 2013, to make contributions for the 2012 tax year, but no extension is permitted. Generally, you can choose from a wide range of investment options for either type of account, but investments in most collectibles are not permitted. Now let’s look at the main differences:

Traditional IRAs: Contributions may be wholly or partially deductible. But deductions are phased out if your modified adjusted gross income (MAGI) exceeds a specified level and you (or your spouse if you are married) are an active participant in an employer-sponsored retirement plan. Therefore, for many individuals, no part of the contribution to a traditional IRA is tax-deductible.

When you receive distributions from a traditional IRA, you are taxed at ordinary income tax rates on the portion representing deductible contributions and earnings. In addition, you will have to pay a 10% penalty tax on withdrawals made before age 59½, unless one of the special tax law exceptions applies.

Roth IRAs: As opposed to a traditional IRA, contributions to a Roth IRA are never tax-deductible, regardless of your MAGI. But there is a potential payoff on the back-end that you cannot realize with a traditional IRA: qualified distributions from a Roth IRA in existence for at least five years are 100% tax-free. For this purpose, qualified distributions include withdrawals made after age 59½, those made on account of death or disability, or those used to pay qualified first-time homebuyer expenses (up to a lifetime limit of $10,000).

Other distributions are taxed at ordinary income rates under special “ordering rules.” Contributions are treated as coming out first, followed by conversion and rollover amounts and earnings. Thus, even if you do not receive qualified distributions, part or all of the payout may be tax-free.

Due to the lure of tax-free distributions, you might consider converting some or all of the funds in your traditional IRA to a Roth IRA. This may also protect high-income taxpayers in the future from the new 3.8% Medicare surtax on net investment income. (The surtax takes effect in 2013.)  But be aware that the conversion itself is taxable at ordinary income rates just like a withdrawal. If you have funds being transferred to pay the resulting tax, it will dilute some of the tax benefit.

Which type of IRA is best for you? It depends on a number of variables and your personal circumstances. Rely on your professional advisers to provide guidance.