Many of us have heard of the Roth IRA, but not many of us know about the man behind the name. William Roth, Jr., an Army vet and graduate of Harvard business and law, represented Delaware in both the House and Senate in DC for more than 30 years. Though best known for the retirement account that bears his name, he was also recognized as a virulent combatant of wasteful government spending. Mr. Roth passed away about 5 years ago, but his name and legacy lives on through is baby, the Roth IRA.

The Roth IRA is an individual retirement account that taxpayers may establish independent of any other employer sponsored retirement accounts. The Roth IRA offers tax benefits to its account owner. Initially becoming available in 1998, the Roth IRA differs in several ways from its predecessor and counterpart, the Traditional IRA. And in most situations, the Roth IRA is a more effective tax sheltering vehicle than the Traditional IRA.

The differences between Roth IRA and the Traditional IRA are quite simple. However, the implications of those differences are not as simple.

The Major Differences and Implications

1 – In a Roth IRA, contributions are made with post tax dollars. In a traditional IRA, contributions are mare with pre tax dollars.

Implication – Your taxable income is not reduced by the amount of your Roth IRA contributions. Your taxable income is reduced by the amount of your Traditional IRA contributions. Therefore an immediate benefit may exist with the Traditional IRA, as your contributions have the potential of reducing your tax liability in the current year.

2 – Your principal contribution in both accounts grows tax free. However, withdrawals from Traditional IRA are considered taxable income. But because Roth IRA contributions are originally made with post tax dollars, withdrawals are not taxable income.

I guess this can be construed as a pay now or pay later scenario… either way, you have to pay. But there is one gigantic caveat… withdrawals consist of principal and interest. When withdrawing from a Traditional IRA account, the interest earned on contributions is also considered taxable income. Quite the contrary is true with Roth IRAs; interest earned is not considered taxable income.

Implication – In a Traditional IRA, both principal and interest earnings is taxable at the point of withdrawal. In a Roth IRA, neither principal nor interest earnings is taxable at the point of withdrawal.

So which account is better? Well it depends… in some situations it may be more advantageous to have a Traditional IRA and in other situations it may be more advantageous to have a Roth IRA.

A Traditional IRA might be right for you if…

- You are looking for ways to reduce your tax liability today

- You like the idea of paying taxes on the back end

A Roth IRA might be right for you if…

- You like the concept of paying taxes on the front end

- You expect your income tax bracket will be higher in retirement than it is currently (This way your contributions will be taxed at the lower tax rate)

- You do not want to pay taxes on the interest earned on your principal contributions

- You like to simplify your tax reporting (with a Traditional IRA, your have to report contributions and withdrawals on a 1040)

With that being said, for most people the Roth IRA is a better deal. Both types of IRAs have advantages, disadvantages and limitations. But don’t let the fancy tax talk hinder you from taking action. Regardless of the retirement savings tool you use, it works best when you take advantage of your options early. The sooner you start, the better.