The Traditional IRA and Roth IRA share many similarities. However, it is the differences that usually cause an individual to choose one over the other. For those who are trying to decide between the two, consideration should be given to whether they can afford to give up any tax deduction now in exchange for tax-free distributions later;  and their current tax-bracket compared to their projected tax bracket during retirement. 

See the Roth IRA Vs Traditional IRA 2007 and 2008 comparison chart for highlights of a comparison of the features and benefits of a Roth IRA

Determining Eligibility for a Roth IRA Contribution

The first step in choosing between a Roth IRA and a Traditional IRA is to determine whether the individual is eligible to make a Roth IRA contribution. If ineligible to make a Roth IRA contribution, then the options are to make a deductible or nondeductible Traditional IRA contribution.  

An individual with eligible compensation can contribute to a Roth IRA, providing his/her modified adjusted gross income (MAGI) does not exceed certain amounts. The chart below shows these amounts.  

Note: An individual whose compensation falls within the range that permits a ‘partial’ contribution is required to use a formula to determine the amount of contribution that is allowed. 

If Ineligible For a Roth IRA Contribution

If an individual is not eligible to contribute to a Roth IRA, then the next step would be to determine if they are eligible to deduct the Traditional IRA contribution. 

Determining Deductibility

A Traditional IRA contribution is fully deductible, if the individual is not an active participant, or married to an active participant. If the individual is an active participant, or married to an active participant, the deductibility of the contribution is based on his/her marital status, and MAGI amount, as indicated in the chart below. 

Note: An individual whose compensation falls within the range that permits a ‘partial’ deduction is required to use a formula to determine the amount of contribution that is allowed. 

If Ineligible For a Roth IRA Contribution and Deduction

An individual who is ineligible for a Roth IRA contribution and also ineligible to deduct a Traditional IRA contribution may choose to make a nondeductible contribution to a Traditional IRA. 

Nondeductible Traditional IRA Contributions

Individuals who make nondeductible contributions to Traditional IRA are required to file IRS Form 8606, to inform the IRS that the contribution is nondeductible. Form 8606 helps the individual to keep track of the basis created by the contribution, so as to prevent taxation on distribution of those amounts.  

When Eligible For Both a Roth IRA Contribution and a Deduction

An individual who is eligible to make a Roth IRA contribution and is also eligible to deduct a Traditional IRA contribution must decide which is more suitable for his/her financial profile. The answer depends on several factors, which include the following:

• Whether it is affordable to give up the tax deduction now, and if so

• Whether it is more beneficial to give up the deduction now, in exchange for the tax-free growth. This ties into whether the tax bracket will be lower when making the contributions vs when the withdrawals will be made, and

• Whether the objective for saving is to leave the assets to beneficiaries

Affordability

Taking a tax-deduction for an IRA contribution reduces the immediate financial impact of the contribution, by offsetting the contribution with the deduction. Additionally, if the individual meets the requirement for the Saver’s Credit, the financial impact would be further reduced by the nonrefundable credit received, which can be up to $1,000.

Tax Bracket

Typically, an individual who will be in a higher tax bracket during retirement will find it more tax-efficient to fund a Roth IRA instead of a Traditional IRA, as this would result in a lower amount of taxes being paid . However, in cases where there is substantial growth on the investments, it is almost (always) more tax-efficient to contribute to a Roth IRA instead of a Traditional IRA. In order to make a realistic determination, an analysis which includes current tax rate and projected tax rate during retirement, should be done. 

Estate Planning

If the objective is to leave tax-free assets to beneficiaries, and the individual can afford to forego the tax deduction, a Roth IRA would be a better choice 

Choose Both

An individual who is eligible to make a Roth IRA contribution and is also eligible to deduct a Traditional IRA contribution, but is unsure of which is more suitable, can enjoy the benefits of both types of IRAs by splitting the contribution between both. Care should be taken to ensure that the aggregate contributions do not exceed the limit in effect for the year. 

Special Rules for Members of the Armed Forces Serving in a Combat Zone

Members of the armed forces who are serving in a combat zone and receive tax-free combat pay may use such pay as eligible compensation for purposes of funding an IRA. This is an exception to the rule which requires IRA contributions to be based on taxable compensation received by the IRA owner (or the IRA owner’s spouse in the case of a spousal IRA). For these individuals, a Roth IRA would be the better choice because of the following reasons:

•  Since the pay is not taxable, there is no taxable compensation from which to deduct a contribution. Therefore, making the contribution to a traditional IRA provides no benefit, other than adding to the individual’s retirement nest-egg, which can be achieved by adding the amount to a Roth IRA.
• If the amount is contributed to a traditional IRA, it could be taxable when distributed from the traditional IRA, as opposed to a Roth IRA from which distributions could be tax-free.
• Contributing the amount to a Roth IRA means the individual receives a twofold benefit
  1. Unlike other individuals, they would not pay taxes (use after-tax income) on the amount that is used to fund the Roth IRA, and
  2. Similar to other individuals, distributions of those amounts would be tax and penalty free. Additionally, if the distribution is qualified, distributions of earnings and interest accrued on the amount would also be tax and penalty free.

Of course, this is assuming that the individual has no income other that the combat pay. While it may seem practical to assume someone serving in the armed forces has no other compensation, it is not inconceivable that they could receive compensation from other sources. For instance, if the individual was not serving during a portion of the year, and received compensation for working for a business he or she could receive taxable compensation.  If this, or any other circumstances results in the individual being eligible to deduct a traditional IRA contribution, then the points mentioned above would need to be considered.

Conclusion

When deciding between a Traditional IRA and a Roth IRA, the focus should be on the differences. For instance, if the individual is eligible to deduct the Traditional IRA contribution, does it make sense to forego the deduction in return for tax-free distributions? Also, consider which IRA will result in the individual receiving a higher net amount after income taxes. Roth IRA Vs Traditional IRA analyses make certain presumptions, including rates of return on investments, and income tax rates. Similar to other financial planning exercises, the results may not be identical to the projections made in the analysis.  However, they provide a good basis on which educated decisions can be made.