Traditional IRA vs. Roth IRA: Deciding the Best way to Save for Retirement

Ever since I began college I have heard the same daunting words "Your generation can't depend on Social Security. You better start planning for retirement now."

The words Traditional IRA, Roth IRA and 401k have been thrown around too many times to count. But what do these series of letters and numbers truly mean? More importantly, which will leave me the best situated for living out my golden years on the shores of Tahiti?

I will be writing a short series of blogs to outline the pro's and con's of each retirement plan so that you can decide for yourself.

Traditional IRA vs. Roth IRA:

Tax Benefits:
For sake of illustration, you could think of it as the opposite of a credit card...Would you rather save now, or save later? (Its much more complicated than that but lets keep it simple for the sake of general concept.)

-A traditional IRA allows a tax deduction on annual contributions, but when you take the money out upon retirement (age 59 1/2 or later) you must pay taxes on all capital gains, interest, dividends etc. earned.
-A Roth IRA does not give you a deduction for your contribution but all retirement withdrawals are 100% tax-fee.

Annual Contribution Limit:
Both have a limit on the amount of pre-tax dollars that can be placed in them per year, in 2008 the annual limit was $5,000.

Penalties for Early Withdrawl:
-Traditional IRAs will hit you with a 10% penalty for any withdrawal before age 59 1/2.
-Roth IRAs have no penalty on early withdrawal of principal (that principal has already been taxed as income).

Distribution Age:
-Traditional IRAs will allow withdrawals free of penalty after age 59 1/2. Withdrawals are mandatory after age 70 1/2. (Yeah...you aren't mature enough until halfway through the year apparently. The IRS loves mid-month conventions.)
- Roth IRAs allow withdrawal of interest free of penalty after age 59 1/2, but have no mandatory distribution age.

Investment Options:
Both funds can be used to purchase a variety of investments (stocks, bonds, certificates of deposits, etc.).

Eligibility:
The overall benefits are looking good for the Roth IRA supporters... but here is the kicker...

-Roth IRAs are only allowed for single filers with up to $101,000 income (to qualify for a full contribution); $101,000-$116,000 (to be eligible for a partial contribution). Joint filers up to $159,000 (to qualify for a full contribution); $159,000-$169,000 (to be eligible for a partial contribution).
-Traditional IRAs are available to everyone.



NEXT: Will 401k's beat IRA's in the battle of the best way to save for retirement?