Just about everyone has heard of Individual Retirement Accounts (IRA), but there is often confusion about how a Traditional IRA differs from a Roth IRA.  As the name indicates, both are accounts that an individual has set up to fund with retirement contributions.  You can set up the account with a bank or a brokerage firm.  You put money into the account and allocate it into various types of investments such as certificates of deposit, stocks, bonds, or mutual funds. 

For a Traditional IRA, the contribution may be deductible on your personal tax return, depending on whether you are covered by another plan and your level of income.  The earnings on the investments are tax free until you begin withdrawing money, at which time the distributions are fully taxable.  Generally, you can make withdrawals without penalty once you are 59 1/2 and you must begin taking withdrawals once you reach 70 1/2.  The advantage is tax deferral on the earnings and the possibility that you are getting a tax deduction during high earning years, then later receiving the taxable income during retirement when you may be in a lower tax bracket.

Contrast this scenario with a Roth IRA, in which you get no deduction on your tax return when you make the contribution, but the investment grows tax-free with no tax paid when money is distributed.  Distributions of earnings are allowed without penalty once you have reached 59 1/2 and have had amounts in the account for at least five years.

The difference in these two types of IRAs allow for significant tax planning opportunities.  The longer time that the Roth can grow, the more advantageous it is.  A young person who is in a low tax bracket would have many years of potential tax-free growth.  (Roth 401k plans may also be available through your employer.) There is no requirement to begin making distributions of Roth IRAs at any age and tax-free transfers can be made to beneficiaries, so there are significant estate planning factors as well. 

While it can be difficult to estimate your income and tax situation in retirement, one factor to keep in mind is that under the current tax law, social security benefits may be taxable depending on your income level.  If all of your retirement savings are in traditional IRAs or retirement plans, any distribution that you take could trigger taxes on your social security income as well as the tax on the distribution itself.  A Roth IRA allows you to have some of your retirement money in an account that does not trigger taxable income.

One planning strategy is to transfer funds from your Traditional IRA into a Roth IRA.  This transfer is a taxable event, but is not subject to the 10% early withdrawal penalty.  It is wise to consider this strategy in a year in which you have low income or your investments are at a low mark.  In 2009, you can make this transfer only if your other income is less than $100,000.  However, for 2010 distributions there is no income limitation and half of the distribution is taxed in 2011 and half in 2012.

Due to the complexity of these tax laws, you should consult with your tax professional regarding such issues.  Depending on your circumstances, a Roth IRA can be a very valuable tool.

Jean M. Diamond CPA

847-441-3391