It’s a common question.  With a relatively simple answer.

 Contributions made to a Traditional IRA go in pre-tax.  So, if your income is $65,000 and you make a $6000 Traditional IRA contribution, your taxable income is reduced to $59,000, so you have not paid income tax on that money.  Then the funds grow tax deferred, meaning that you don’t pay tax on the earnings from year to year.  When you make withdrawals from the IRA in retirement, you pay tax on every dollar that comes out because you’ve never paid tax on any of it. 

 You can think of a Roth IRA as just the opposite with a little bit of a twist.  Contributions made to a Roth IRA go in after-tax.  If your income is $65,000 and you make a $6000 Roth IRA contribution, your taxable income is still $65,000, and you have already paid income tax on that money.  Then the funds grow tax-free.  Assuming you follow all the Roth IRA rules, when you make withdrawals from the Roth IRA in retirement, the entire withdrawal, including earnings, comes out tax-free.

 Both Traditional and Roth IRAs allow penalty free withdrawals after age 59 ½.  However, the Roth IRA has an additional 5-year rule.  The rule states that you can’t take funds out of the Roth IRA for 5 years after you start it or there is a penalty, and age doesn’t matter.  If you start it at age 60, you can’t touch the funds until age 65 without penalty even though you are over 59 ½.  But the Roth IRA also allows you to pull out your contributions (not earnings) at any time without penalty, even before 59 ½, if you have met the 5-year rule. The Traditional IRA requires you to start taking RMDs (Required Minimum Distributions) at age 72, where as a Roth IRA has no RMD requirements.

 To determine which is best, you must look at your individual circumstances.  Some things to consider are: Do you need a tax deduction?  Do you already have a sizable 401k in pre-tax money and need a tax diversification strategy?  Will you pay more tax on that money now versus later?  While some of these questions may be easy to answer now, some are not.  Over time it may pay off to have both and evaluate which makes most sense from year to year.

 This is the most simple explanation, but there are a lot of exceptions to contributions and distributions.  The IRS Publications 590-A & 590-B give you all the details over the course of approximately 130 pages.  So, if you don’t want to weed through all those details for your specific situation, call on a professional, like your Financial Advisor and/or CPA, to guide you.

 Contributions to a traditional IRA may be tax-deductible depending on the taxpayer’s income, tax-filing status, and other factors. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty. Like Traditional IRAs, contribution limits apply to Roth IRAs. In addition, with a Roth IRA, your allowable contribution may be reduced or eliminated if your annual income exceeds certain limits. Contributions to a Roth IRA are never tax deductible, but if certain conditions are met, distributions will be completely income tax free.

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Every investor’s situation is unique, and you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with your financial advisor about your individual situation.

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