Can someone give me the Straight Dope on traditional IRAs versus Roth IRAs? I’m looking into starting an IRA soon, and the research that I’ve come across so far is beginning to make my head spin, particularly in regards to taxation. Does one flavor of IRA have a particularly significant advantage over the other?
With a traditional IRA, the money you deposit is not taxed. For example, you earn $50,000 in one year. Of that, you contribute $5000. The $5000 goes untouched taxwise, and you only pay taxes on the $45,000 that is left. When you withdraw the money later (59 1/2 or after), only then will it start being taxed at your ordinary income tax rate.
With a Roth IRA, it’s the opposite, sort of. Using the above example, you are taxed on the full $50,000, even if $5000 was contributed. The difference is, when you withdraw the money later, none of the money is taxed. (If you followed all the rules.)
So which is better? It depends on when you start your IRA, and how much you plan to invest in it.
Fool.com has a nifty calculator for this, as well as more information about IRAs.
For many people the option to invest in a deductible traditional IRA no longer exists. You have to meet several income criteria as well as not having an employer sponsored plan available to you.
If your choice is between a non-deductible traditional IRA and a Roth your choice becomes clearer. In a non-deductible IRA your earnings will be subject to tax at a later date, so you are gaining only the benefit of tax-deferral of earnings. In a Roth earnings are completely tax free.