Differences between Traditional IRA & Roth IRA - 8 Exceptions to the 10% Early Withdrawal Penalty

(March 8th, 2008)

Interestingly, there are 11 different types of IRAs ranging from Individual Retirement Accounts, Employer and Employee Association Trust Account, Spousal IRAs, Rollover Conduit IRA, etc. The most common are the traditional IRAs and the Roth IRA. In this article, we will explain the differences & similarities between the two.

Traditional IRA

In Traditional IRA, the contributions you make towards the account are not taxed. Whatever capital gains & earnings you make on your IRA are also not taxed up until retirement, when you withdraw money from your account. For example, imagine you made $50,000 this year and contributed $5000 to a traditional IRA. You will be taxed on $50,000 - $5000 = $45,000. Furthermore, your $5000 contribution will grow tax-deferred for many years, until you retire and decide to withdraw it. The setback with this is that your $5000 (which would have probably grown to $50,000 upon retirement) will then be taxed at your ordinary income tax rate.
Note: You can only withdraw this money after you turn 59 and 1/2 years or older. Any withdrawals made before this age will be subject to income taxes as well as a 10% early withdrawal penalty. However if you use the withdrawn funds to finance higher education expenses or for the below list of 8 exceptions, you will not have to pay the 10% early withdrawal penalty.

8 Exceptions that Eliminate the 10% Early Withdrawal Penalty

There are 8 exceptions to the 10% early withdrawal penalty (i.e. withdrawals that are taken before the age of 59 and 1/2). They are for distributions that:

i) Are taken because of the IRA owner's disability

ii) Are taken because of the IRA owner's death

iii) Are a series of loan repayments made over the life expectancy of the IRA investor

iv) Are used to pay for unreimbursed medical expenses that exceed 7.5% of the adjusted gross income of the IRA owner

v) Are used to pay for medical insurance premiums if the IRA investor has been unemployed for more than 12 weeks

vi) Are used to pay for the purchase of a principal residence (maximum of $10,000 can be withdrawn). Also, the IRA investor must not have previously owned a home within the last 24 months.

vii) Are used to pay for higher education expenses of the IRA owner or eligible dependants/family

viii) Are used to pay back taxes of an IRS levy placed against the IRA

Traditional IRAs are commonly associated with the old way of investing: certificates of deposits. This stereotype is because most banks sell CDs and they are the ones that offer Traditional IRA accounts for investors. But remember, you are not limited to investing Certificates of Deposit or bonds only, you can make higher risk investments such as cyclical stocks, commodities, futures, ETFs, etc.

Traditional IRAs are commonly associated with the old way of investing: certificates of deposits. This stereotype is because most banks sell CDs and they are the ones that offer Traditional IRA accounts for investors. But remember, you are not limited to investing Certificates of Deposit or bonds only, you can make higher risk investments such as cyclical stocks, commodities, futures, ETFs, etc.

The Roth IRA

Pioneered by the late Senator William V. Roth, Jr., the Roth IRA came into existence on January 1, 1998 thanks to the Taxpayer Relief Act of 2007. The Roth IRA is unique from all the other retirement accounts because all the earnings you accumulate on your savings will grow tax-free when you withdraw them upon retirement. The only catch to this is that when you make the initial Roth IRA contributions, you will receive no deductions on your income tax return. Other benefits of the Roth IRA include the elimination of the minimum required distributions rule when you turn 70 and 1/2 years old (more on this below).

By making after-tax contributions to your Roth IRA, you will not owe a single dime of tax to Uncle Sam when you retire and withdraw your money. This adds the advantage of being able to grow your earnings tax-free not for the government, but for yourself! Which retirement plan is therefore the right choice for you? Well it depends on your personal situation. If you expect to be in a higher tax bracket when you retire, it is better off to pay the taxes right now and grow your savings tax-free in a Roth IRA. Because a Roth IRA holds after-tax dollars, you can maximize your contributions by adding greater tax leverage to your retirement savings.

After-Tax Contributions?

Consider Jackson who earns a $65,000 annual salary. Jackson is currently in the 25% tax bracket and contributes $3500 a month to his Roth IRA. Jackson would therefore pay income taxes of $3500 x 25% = $875 and would contribute $3500 - $875 = $2625 to his Roth IRA. If Jackson expects to be in a 33% tax bracket upon retirement, he will have to pay $3500 x 33% = $1155 upon his retirement. Therefore by making after-tax Roth IRA contributions now and getting taxed at the lower 25%, Jackson avoids having to pay taxes @ 33% when he hits retirement.