There are actually eleven different types of IRAs, but the two main IRAs for individuals are the Traditional IRA and Roth IRA. There are many similarities (for instance, the Roth IRA deadline is the same as that of the Traditional IRA), but there are some key differences differences between these two types of individual retirement accounts:
Traditional IRA
When you make a contribution (a deposit) to your Traditional IRA, the money is not taxed; rather, it is taxed when you withdraw the funds. When you make a contribution to an IRA, you get a tax deduction on that year’s tax return. For example, if you earn $34,000 and contribute $2,000 of your earnings into an IRA, your taxable income is $32,000. The amount of your deposit will grow the entire time it’s in the Traditional IRA tax-free. After you retire and start taking money from your IRA, that is when you will pay tax on the money as income.
If you should withdraw money from a Traditional IRA before you reach the age of 59 and ½ years, then you’ll pay income tax on the money you withdraw and a 10% early withdrawal penalty unless the funds are used for one of eight exceptions to the 10% early withdrawal rule.
Roth IRA
When you contribute money to a Roth IRA, the contribution is not tax-deductible like it is with a Traditional IRA. So if you earn $34,000 and contribute $2,000 into a Roth IRA – you still pay income taxes based on $34,000. With a Roth IRA, however, when you withdraw the money under qualified distribution rules, none of the contributions you made or the earnings of the fund will be taxed. If you withdraw the money before you are age 59 and ½ years – you will still be subject to an early withdrawal penalty of 10%, and you will pay taxes on the amount of money you withdraw early. Also, unlike a rollover to a Traditional IRA, a 401k rollover to Roth IRA is a taxable event.
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