What is the difference between a Traditional IRA, Roth IRA, and Rollover IRA?
From FinancialPlanning
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General
These terms all describe types of accounts that you can open at a variety of financial services companies: banks, brokerage firms, mutual fund companies, insurance companies. The purpose of all of them is save money for retirement, and you can receive substantial tax benefits as long as you follow the rules for using them.
A separate question is what you'll purchase with the dollars within the IRA(s). This article addresses just the account types; see also the page on How should I invest the money that's in my IRA?
Traditional IRAs
Traditional IRAs were once the only type of IRA available. The key features of "Trad-IRAs" are:
Tax Deferral
Your money grows tax-deferred within the account, meaning if you earn interest or dividends, or realize capital gains when you sell a stock or mutual fund, there's no tax owed at that time. Because of this tax deferral, investments held in an IRA grow more quickly than if you held them in a taxable account. Money that you would be paying out to income taxes is instead reinvested.
Taxes owed at Distribution
With a Trad-IRA, you will pay taxes when you take money out of the account. Distributions are taxed in the same way as salary, wage, or interest income on your tax return, meaning at ordinary income rates. If you withdraw $20,000 from your IRA, you pay income taxes as if you had earned $20,000 in wages -- it's just another line of income on the front page of your Form 1040 filed with the IRS. States typically tax this distribution as well, though some have exemptions for all or part of the IRA distribution (check with your home state).
Penalty for withdrawal before age 59 1/2
The account is intended for retirement savings, so if you withdraw money before age 59 1/2, you also pay a 10% penalty on the withdrawal. There are several exceptions to the penalty, which are discussed in IRS Publication 590. States may also impose a penalty on early withdrawals.
MIFP Tip: In general, you will give up a lot of money to taxes and penalties if you take a premature distribution from your IRA...it can eat up 50% or more the amount withdrawn. For this reason, posters who ask about taking money from their IRAs early are usually strongly discouraged from doing so, unless it's the only source of funds.
Contain Pre-tax Dollars (mostly)
Trad-IRAs usually contain pre-tax dollars. This means that the IRA was funded with money that was deducted on the owner's income tax return in the year of the contributions, leading to a tax benefit in those years. If your income was $40,000 before the contribution and you contributed $4,000, it was as if you earned only $36,000 that year - you avoided federal and state income taxes on the $4,000 you contributed.
Trad-IRAs may also contain after-tax dollars. This happens when you make a contribution to the IRA in a year that you can't deduct the contribution on your tax return. These after-tax dollars establish what is called "basis" in your IRA. The effect of basis is that your distributions will be taxed slightly less than if the account contained entirely pre-tax dollars (the portion of the account that is after-tax dollars isn't taxed at distribution; as an example if 5% of your account at the time of distribution is after-tax dollars then 5% of your distribution won't be taxable).
After-tax contributions are tracked on IRS form 8606, "Nondeductible IRAs," which you need to fill out each year that you make a nondeductible contribution, and each year thereafter to track your IRA basis. From posts on MIFP it appears that quite a few people forget to file this form and lose track of IRA basis.
Minimum Required Distributions
You are required to being drawing money from your IRA each year, once you reach age 70 1/2. The amount you're required to distribute is a percentage of the account value on 12/31 of the prior year. This percentage increases slightly each year. You may take out more than required distribution amount, but if you take out less you're hit with a harsh penalty: 50% of the amount you should have taken out, but didn't.
Tax Generally Unavoidable
Because Trad-IRAs contain before-tax dollars, it's hard to avoid paying taxes on them. The 2006 Pension Act allows for charitable contributions to be made with IRA dollars, and you can figure out ways to leave an IRA to charity. But generally you or your beneficiaries are going to be taxed at the time of withdrawal. For individuals with large IRAs this can lead to tax issues for them or their estate (the IRA could in theory be subject to both estate tax and then income tax at time of withdrawal). Though some MIFPers say, we all should be so lucky!
Roth IRAs
Roth IRAs were introduced in 1997, and are one of the favorite topics and tools of MIFP readers. The reason is that they are one of the very few ways to earn truly tax-free income on your investments. They have some similarities to Traditional IRAs but there are important differences in tax treatment:
Tax Deferral
Same as Trad-IRA.
No taxes owed at Distribution
As long as you meet the distribution rules, there are no taxes owed at distribution. Money you take out is completely tax free. This means, in effect, that all of your earnings in the account are permanently tax-free. If your $4,000 contribution grows to $10,000, $100,000 or $1,000,000, it's all yours.
Penalty for withdrawal before age 59 1/2
As with Trad-IRAs, you have full access to the money only after age 59 1/2. But Roth IRAs contain after-tax dollars (see below) so early withdrawal rules are more flexible. You can withdraw your original contributions, including amounts converted from a Trad-IRA, under some circumstances. Withdrawing earnings is still subject to penalty.
Contain After-tax Dollars
Roth IRAs only contain after-tax dollars. This means that the Roth IRA was funded with money that was not deducted on the owner's income tax return in the year of the contributions, so there was no tax benefit in those years. This also means that some people will see a larger net tax benefit from contributing to a Trad-IRA instead of a Roth IRA.
Two ways to put money in: Contributions and Conversions
As with a Trad-IRA, you are allowed to contribute a certain amount of cash into the account each year, as long as you meet the rules on contributions (see separate FAQ on contributions). But you're also able to get money into them by converting Trad/Rollover IRAs into Roth IRAs. In practice, many people will be able to get much more into their Roth IRA through conversions than through contributions. For example, in 2006 the annual contribution limit is just $4,000. But if you leave a job and have $40,000 in your 401(k) plan, you could move those dollars to a Roth IRA, pay the associated taxes, and in effect make 10 years of contributions in a single shot. You could also make the $4,000 contribution as long as you met the rules for that!
Roth conversions are a complicated topic, so they're discussed at length in their own section of the FAQs.
Minimum Required Distributions
Unlike Trad-IRAs, Roth IRAs do not have minimum required distributions at any age, and the tax-free nature carries on to beneficiaries. This makes them a very good vehicle for passing on wealth.
Rollover IRAs
A Rollover IRA is just a type of Traditional IRA that contains money that you've transferred (rolled over) from an employee retirement plan such as a 401(k) or 403(b). At one time it was important to keep these "rollover" assets from your "contributory" IRAs, and that's why most financial firms still code the accounts as "Rollover IRAs" or "Traditional IRAs" when you fill out your account application. But the distinction has become less important since the tax bill in 2002 (EGTRRA) which loosened up the rules for transferring money around among these different types of accounts, and it's not as much of a problem to combine contributions and rollovers within the same IRA.
References
IRS Publication 590, "Individual Retirement Arrangements," goes into detail about everything above.
