Step 3: Roth vs. Traditional IRA

The one question we get the most at our Rule Your Retirement newsletter service is whether to use a traditional IRA or a Roth IRA. In a nutshell, what is the difference? We're glad you asked.

Traditional IRAs
The tax breaks for a traditional IRA are of the "this is tax-deductible" kind. That means that, depending on previously discussed factors, the money you deposit in your IRA isn't taxed. And regardless, whatever earnings you have on your contributions won't be taxed until you withdraw that money many years later.

For example, let's say you made $30,000 during the year, and you put $5,000 of it into an IRA. You'll pay income tax on only $25,000 of those earnings. Additionally, your deposit will grow free of tax through the years. When you finally withdraw the money for your retirement -- after age 59 1/2 -- then, and only then, will the money be taxed as income at your ordinary income tax rate.

If you withdraw the funds before age 59 1/2, then in most cases, you'll have to pay both income tax and a 10% penalty on whatever earnings have accrued -- although there are some exceptions where the penalty may be waived.

Remember that you can put just about anything you want in an IRA account. Under the onslaught of marketing from banks, you may have come to the conclusion that an IRA is somehow connected to a CD (certificate of deposit). That's what most banks sell, but be advised, Fool: You're not limited to what the banks offer. If your outlook is Foolish, you'd like to take control of your investing future, and you think you can develop some market-beating returns, then by all means, plunge ahead with IRA and tax savings happily in hand!

The Roth IRA
The tax breaks for a Roth IRA are different. Unlike a contribution to a traditional IRA, a Roth IRA contribution is never deductible. Taking the above example, you'd still be taxed on $30,000, even though you had put the same $5,000 into a Roth IRA. However, when you withdraw the money from a Roth IRA, none of it -- and that includes the earnings -- will be taxed, assuming that the Roth IRA has been open for at least five tax-years, and that you're older than age 59 1/2. That's right -- you get off scot free with the booty. All you have to do is to wait until you can withdraw it penalty-free. Again, that's after age 59 1/2, and as long as the cash in question has been in there for at least five years.

In other words, the Roth offers tax-exempt, rather than simply tax-deferred, savings. One word makes a big difference. While both allow you to accumulate wealth without paying taxes along the way on your profits, the traditional IRA ultimately sticks you with a tax bill for those profits (plus your initial contributions, if those were deducted when made). The Roth doesn't. As long as you follow the rules, you never pay taxes on your gains. So paying the piper now, before contributing to the Roth, may work out better for you than paying later on your investment profits.

The Roth makes particular sense for people otherwise limited to making non-deductible contributions to a regular IRA. And the Roth is fully available to single filers making as much as $110,000 in 2012 or $112,000 in 2013, and for couples making up to $173,000 in 2012 or $178,000 in 2013.

It also allows you great flexibility by allowing you, in many cases, to withdraw your principal contributions tax-free at any time, without penalty. First-time homebuyers can also pull out $10,000 in profits penalty-free and tax-free, if the money has been in the Roth IRA for at least five tax years. There are also some breaks for education spending, though a Coverdell Education Savings Account or 529 plan may be better vehicles for education savings. Barring these exceptions, though, profits withdrawn before retirement age, and before the money has been in the Roth for at least five tax years, will be taxed. You'll also incur a 10% penalty when those earnings are taken before age 59 1/2.

You can plug in your own numbers to compare the two types of account by using our IRA calculators.

To convert or not to convert
Because the Roth is potentially better than the traditional IRA, it may make sense for you to convert a current traditional IRA into a Roth. To do so, you will have to pay taxes on your old IRA, but there will be no penalty for early withdrawal. Is this a smart thing to do? The answer depends on your income tax rate today versus that in retirement; how you will pay the income tax bill due on the conversion; how long the Roth IRA will remain untouched; and the size of the IRA coupled with your desires for your estate. For a discussion of some of the considerations involved in making such a decision, see this article.

In general, though, if you have to use your IRA savings to pay taxes triggered by shifting them to a Roth, you may be sacrificing too much principal up front to make the deal worthwhile, unless you have many years to make up for this dip into your savings. You should also note that funds rolled over into a Roth IRA come under greater restrictions for penalty-free and tax-free distributions, compared to normal Roth IRA contributions.

Want to make a quick conversion comparison? Use our handy IRA calculators to plug in your own numbers and see whether conversion is for you.

Once you've solved the "traditional vs. Roth" dilemma, there's just one thing left to do: Open an account.

The article Step 3: Roth vs. Traditional IRA originally appeared on Fool.com.

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