Question of the week: My current employer doesn't offer a 401(k) but I'm determined to continue saving for retirement on my own. I've started to look into individual retirement accounts, but I'm not sure which choice is best--the traditional IRA or the Roth IRA. What do you think? --Naomi G.
Dear Naomi,
When you open your IRA, you'll be in plenty of good company. According to the Investment Company Institute, about 42 percent of U.S. households owned IRAs as of last year. The reason for their popularity is simple: IRAs offer terrific tax advantages that mean you keep significantly more of your money than if it was invested in a regular taxable account.
Your first step in IRA investing is to understand the key differences between the two major types of IRAs. The traditional IRA allows your money to grow tax-deferred until you withdraw it and, in some cases, lets you deduct your contribution. The Roth IRA, on the other hand, allows your money to grow tax-free, but you are never allowed a deduction for your contribution and can contribute only if your income does not exceed a set limit.
When we asked members of the Armchair Millionaire community which type they prefer, we got a range of responses:
Go for the Roth. "For me, hands down the best choice is the Roth. The reason is two of the greatest words ever put together in the English language: TAX FREE!" --Sean D.
Go for the traditional. "I love getting that tax deduction every year, so I always invest the maximum I can in my traditional IRA." --Seattle Sailor
Go for both. "I'm equally invested in both. My income fluctuates, so if I make more than the Roth limit, I invest in a traditional. If not, I invest in a Roth." --Josh L.
To help you decide which type is right for you, use my overview of IRA rules.
The Armchair Millionaire Checklist of IRA Rules
Who can contribute. Traditional IRAs are available to anyone under age 70 1/2 who has any amount of earned income. If you participate in an employer retirement plan, your contribution may not be tax deductible, depending on your income. Roth IRAs are available to anyone earning less than $110,000 (for single filers) or $160,000 (married filing jointly).
How much you can contribute. Both types let contribute up to a combined total of $3,000 for 2002. If you're age 50 or older, this amount is $3,500.
When you can make withdrawals. In general, you'll have to pay a 10 percent penalty, plus taxes, if you withdraw money from a traditional IRA before age 59 1/2. For the Roth, you can withdraw your contributions at any time without penalty, but will have to pay the penalty and tax on withdrawals of your earnings if you're under 59 1/2 and have had the account open less than five years. There are some important exceptions that allow you to avoid these penalties for both types of IRAs, so be sure to check with a tax advisor before making withdrawals.
When you must make withdrawals. You're required to start making withdrawals from (and paying taxes on) a traditional IRA by age 70 1/2. The Roth has no such requirement.
THE BOTTOM LINE: When it comes to choosing between a Roth IRA and a traditional IRA, don't ignore the forest because of the trees. The most important move is to begin and maintain any kind of long term savings plan. Either choice will help to ensure a long and fulfilling retirement.
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