Despite the fact that both Traditional and Roth individual retirement arrangements are termed “IRAs”, they are very different structures that offer very different benefits. A prime example of the differences between the two related to the deductibility of contributions to the two types of IRAs. Quite simply, no money contributed to a Roth IRA is tax deductible whatsoever; instead all contributions are done after tax, so every cent that goes into a Roth is taxed before it even goes into the IRA and there is no option to claim it as a deduction on your annual income tax return. The option of tax deductibility only applies to Traditional IRAs, all of which receive their contributions before taxes and the contributions themselves can be claimed as a deduction against the IRA owner’s personal tax liability.
The primary advantage of Roth IRAs is that since the money is taxed before it goes into the account and it is not deductible, the earnings made on the contributed amount are considered tax free. This is why most financial advisors strongly suggest that their clients use Roth IRAs as part of their overall investment strategy since it represents one of the very few ways allowed by the IRS to actually make money that is completely tax free assuming all the rules are properly followed. In exchange for tax free money once you retire – assuming you make good investments in your IRA and have earnings to withdraw – there are no tax benefits whatsoever in the pre-retirement phase, like tax deductibility.
The Traditional IRA offers an alternative model: specifically it offers tax benefits before retirement, on the understanding that the taxes owed on the money are deferred and must be paid once the IRA owner begins removing money from the IRA. There are fixed contribution limits to all IRAs, so only so much money can ever be contributed in a given year. In the case of a Traditional IRA, this contribution happens before taxes are collected on income and the amount contributed to the IRA can be deducted from the amount owed for that year’s personal income tax liability. Later, once the money is distributed from the IRA, the taxes owed on that money – both the amount contributed and any earning made inside the IRA – is owed in the year that it is withdrawn.
There are also a number of alternative types of IRAs as well, such as SEP IRAs and Simple IRAs, and these also have their on special rules governing all aspects of their operation, including tax deductibility. However, for most people, the Roth and Traditional are the only types of IRA they are ever likely to have. Therefore, the question of tax deductibility has to be seen within the context of the individual’s personal financial position. If immediate annual tax relief is a priority, then a Traditional IRA may be a better option since it offers immediate tax deductibility. If the IRA owner is in a comfortable situation and does not consider their annual tax liability to be too overwhelming, then a Roth is probably the best option over the long run, despite the lack of an immediate tax benefit.