Investment Tips: Ira Vs. Roth Ira

A guide to the two different kinds of Individual Retirement Accounts available: the traditional IRA and the Roth IRA.

There are many ways to save for retirement. Workers have traditionally saved for their golden years in one of three ways: social security, pensions and individual savings. Social security is the primary form of direct retirement savings for most workers. It serves as an easy safety net because all you have to do in order to qualify is work at a minimal number of hours each week for ten years. In addition to making mandatory contributions to social security many companies also provide offer workers with a private pension plan based on their years of service. Private pensions are a nice perk but many employers are phasing them out in favor of other forms of retirement financing.

Another way workers have financed their retirement is through saving and investing. Many people invest in stocks, bonds and real estate. In the last twenty years another form of retirement savings has become popular: the IRA. The acronym IRA stands for Individual Retirement Account. Under current legislation an individual has been allowed to contribute up to $2,000 a year to an account marked for his own retirement.

The IRA's chief advantage is that unlike ordinary income, income deposited into an IRA is tax deductible. The law also allows employers to contribute to an equal amount of tax deductible funds into the IRA, thus giving some people as much as $4,000 a year towards retirement. The IRA also offers employees something they didn't get with a pension: flexibility. Under the traditional pension system an employee had to work a certain number of years before qualifying for a pension. If the employee was laid off or took another job, he lost all money he had contributed. If someone opens up an IRA, any money they put into it is theirs. If they leave the employer they still retain the account.



Money from an IRA can be invested in any form of savings. Most employers offer their employees a choice of several kinds of market investment funds, often with different promises of risk and returns. Initially the only catch was that the savings could not be withdrawn without heavy penalties until you were at least 59 and a half. This law has since been modified. You can now withdraw the accumulated funds without facing additional taxes in case of death, disability, large annual medical expenses, back taxes, college expenses and a down payment on a house.

In the years since the introduction of the IRA, a number of variants on the IRA theme have been put in place. Most of the different kinds of IRA's are unimportant for most people. But there is one kind that everyone should know about and understand: the Roth IRA.

The Roth IRA was named for Senator Roth and was passed in the late 1980's. The main difference between the Roth IRA and a traditional IRA is very simple. Individuals are taxed on the money they initially put into the IRA. They are not, however, taxed on the profits from the account when they withdraw it. If you earn $50,000 and you put away $2,000 you will still get taxed on the $2,000 you earned when you file your taxes that year. The reward is that once you retire and tap the funds in the IRA the funds aren't counted as earnings and the money will not get taxed. All you have to do is invest for five years and wait until you're 59 and a half.

If you and your employer place $4,000 in a traditional IRA for twenty years the account will have grown to roughly $200,000 by the time you retire. Under the terms of the classic IRA when you retire you will pay taxes every single penny of the $200,000. If you invest the money in a Roth IRA, you would have paid taxes on the $4,000 each year but you wouldn't pay anything once you withdrew the final sum.

So which one should you chose? Like everything else in life, the answer depends on your circumstances. If you need the deduction right now, it makes sense to keep a regular IRA. No one should ever be unable to pay their current bills just to pay for retirement. If don't plan on retiring for at least twenty years the power of compound interest should help compensate for the loss of tax deduction later.

If your retirement horizon is shorter, consider the Roth IRA. If you were to invest in the market on your own, you would still have to pay capital gains taxes on the profit you earn. If you chose to invest in a Roth IRA and can wait five years all profit will be tax free. While you may to pinch pennies a little more it's more than worth it to have a source of tax free retirement funds.

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