IRA or Roth IRA?

Individual Retirement Accounts can be part of the foundation of a financially secure retirement. For many years, millions of individuals have made annual contributions to IRAs or used them to receive distributions from retirement plans on changing jobs or retiring. A few years ago, a new form of IRA was created called the Roth IRA. The Roth IRA offers some advantages over the traditional IRA but comes with some limitations.

Here is a comparison of some of the key features of each:

Eligibility
Anyone under the age of 70 ½ with earned income can contribute to a traditional IRA. For a Roth IRA, you must still have earned income but there is no age restriction. However, there are income limits for Roth IRAs. For 2012, single tax return files can make full contributions if their income is less than $110,000. The limit for joint filers in 2011 is $173,000. Partial contributions are allowed if your income exceeds those amounts (up to $125,000 and $183,000 respectively).

Taxability of Earnings
Earnings on funds in a traditional IRA are tax deferred. Roth IRAs provide for tax-free growth.

Contribution Limits
The contribution limits for both types of IRAs are the same. In all cases, contributions must not exceed earned income.

• 2012 contributions - $5000
• After 2012, the limits will be adjusted for inflation in $500 increments.

In addition, workers ages 50 and over can make additional "catch-up" contributions of $1000 for 2012.

Deductibility of Contributions
Contributions to traditional IRAs are deductible if you do not participate in another qualified plan. If you are a plan participant, contributions may be deductible depending on your adjusted gross income.

For 2012 contributions - Single return filers - full deductibility if Adjusted Gross Income is $58,000 or less and partial deductibility with Adjusted Gross Income up to $68,000. For joint return filers in 2011, the limits are $92,000 and $112,000.

Contributions to a Roth IRA are not tax deductible.

Taxability of Withdrawals
For traditional IRAs, any earnings and deductible contributions are subject to tax on withdrawal. All distributions from a Roth IRA are tax-free.

Penalty for Early Withdrawals
Both types of IRAs impose a 10% early withdrawal penalty tax on distributions taken before reaching age 59 ½. There are a few exceptions for death, severe hardship and other situations.

Mandatory Distributions
For a traditional IRA, you must start taking distributions in the year you reach age 70 ½.

Which IRA is right for you?
If your income level precludes you from getting a deduction for contributions, the answer is easy - choose the Roth IRA.

If your contributions to a traditional IRA would be deductible, the question is harder. Generally, if you are younger, the attraction of tax-free distributions would outweigh the immediate benefit of the deductions. If you expect your marginal tax rates to remain at their current level or increase, the odds favor the Roth IRA.

If you have significant other assets and would like to use your IRA to pass significant wealth on to future generations, the tax-free nature of the Roth IRA is extremely attractive.

Should You Convert Your IRA to a Roth IRA?
There are some special rules that enable you to convert a regular IRA into a Roth IRA. Many people find that the attractions of tax-free distributions and no required distributions make a Roth IRA conversion worth considering. However, there are limitations and costs.

First, to be eligible for the conversion, your adjusted gross income in the year of conversion must not exceed $100,000. In addition, you must pay taxes on the accumulated value of the IRA (less any non-deductible contributions you have made) when you make the conversion. As a result of the 2006 tax law changes, beginning in 2010, there will be no income limitations on conversions.

Be sure to consult your tax advisor if you believe converting makes sense. Most professionals have software that can help with the analysis.