What is the difference between a Roth IRA and a traditional IRA?
That question about retirement planning is very common. I’ve written up short answers, detailed answers, courseware, seminars, flyers, tear sheets, white papers, and who knows what else about what a Roth IRA account is versus a traditional IRA account.
Lately, the questions, while similar have gotten more varied:
- What is the difference between a SEP-IRA and a SIMPLE IRA?
- What is the difference between a Rollover IRA and Traditional IRA?
- What is the difference between a regular IRA and special IRA?
That last one says to me that somewhere out there, there is a popular financial planning book, personal finance speaker, or television show using terminology that is either inaccurate, or poorly understood. Either way, here is a crash course in all the types of IRAs, what they are, how they work, and who they are for.
Regular IRA Accounts – Individual IRAs – Personal IRA Accounts – Normal IRA Accounts
Let’s start at the beginning.
All IRA accounts are, by definition, personal IRA accounts, or individual IRA accounts. There is no such thing as a joint IRA. There is no such thing as an IRA account with more than one owner.
An IRA, according to the IRS, is an Individual Retirement Arrangement. The ‘i’ in IRA stands for Individual. All IRAs are Individual IRAs.
There is no such thing as a regular IRA account or a normal IRA account. However, when most people say such a thing, they mean traditional IRA, which was the first widely known IRA account to exist, and is thus, often considered “normal” or “regular.”
Traditional IRA Versus Roth IRA
If you want an in-depth explanation of how IRAs work then click the link. Otherwise, here is the short, short, version.
A traditional IRA offers (some) people a tax deduction up front when you contribute the money. In exchange, you owe taxes on all money in an IRA when you withdraw it, no matter how old you are.
The same thing applies to 401(k) plans, 457 plans, and 403(b) retirement plans.
A Roth IRA works in reverse. You get no tax deduction for Roth IRA contributions today. However, when you retire, you can take all of the money out of a Roth IRA tax-free, including all interest and capital gains.
If you are licking your lips, then you understand the power of the Roth IRA. Years of tax-free compound interest will generate more money than you could ever possibly save by deducting a few thousand dollars per year on your taxes.
Since no taxes are due on money inside a Roth IRA, the IRS doesn’t care if you ever take it out, so there are no required minimum withdrawals, or RMDs necessary on a Roth IRA.
For traditional IRA accounts, you must begin taking an RMD after age 70 1/2, until you die.
Next: Small Business IRA Plans