Individual Retirement Accounts (IRA) come in two types, Roth and Traditional, and there are several basic differences between them.
The biggest difference between these two types of IRAs deals with how the distributions are taxed. Traditional IRAs allow the IRA holder to take a current tax year deduction for the amount which they contributed to the IRA up to an annual limit. When the IRA holder takes a distribution out of the IRA during retirement, however, each dollar of the distribution is taxed as income in the year it is withdrawn. Thus any investment earnings in the traditional IRA are taxed deferred until withdrawn. Earnings in a Roth IRA, however, are tax free when withdrawn, but do not provide a current tax year deduction.
For those covered by an employer sponsored retirement plan traditional IRAs have income limits pertaining to the amount that the account holder may deduct on their taxes; however, anyone can make a nondeductible contribution regardless of income. Conversely, you may only contribute to a Roth IRA if your income is below a certain amount.
Another difference is that Roth IRAs do not require a Required Minimum Distributions (RMD) from the account when the account holder reaches age 70 ½ where traditional IRAs do.
Finally, with a traditional IRA there is a 10% penalty on withdrawals prior to attaining age 59 ½ unless an exception applies. For Roth IRAs this penalty only applies to the earnings withdrawn and not the contribution amount.
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