The Taxpayer Relief Act of 1997 introduced a new type of individual retirement account (IRA) known as the Roth IRA. Named for Senator William Roth of Delaware, who was the Chairman of the Senate Finance Committee at the time, the Roth IRA differs from the traditional IRA in that contributions to it are not deductible.
The Roth IRA: A Different Approach to Tax Relief
Unlike the traditional IRA, the Roth IRA does not offer tax relief on the front end. Contributions to a traditional IRA are tax-deductible, which can provide an immediate tax cut for the contributor. In contrast, contributions to a Roth IRA are not deductible, so there is no immediate tax benefit.
However, there are some key benefits to the Roth IRA that make it an appealing option for many taxpayers. The biggest advantage is that withdrawals from a Roth IRA are tax-free. This means that the full amount of the account will be available to support the contributor in retirement without any further taxes required.
For those who exceed the contribution limits for a traditional IRA, the Roth IRA may be the obvious choice. They can withdraw money from their traditional IRA, pay taxes on the withdrawal, and then deposit the after-tax amount into a Roth IRA.
Conventional and Roth IRAs: Identical in Theory
Although the traditional and Roth IRAs may sound quite different, in fact, they offer virtually identical tax benefits. Both types of IRAs provide a way for taxpayers to save for retirement and reduce their tax liability.
The main difference between the two is the timing of the tax benefit. With a traditional IRA, the tax benefit comes on the front end, with contributions being tax-deductible. With a Roth IRA, the benefit comes on the back end, with withdrawals being tax-free.
Consider a Roth IRA:
For a person who’s tax rate is lower in the retirement than when they contributed to the account, a Roth IRA might be the better option because they would pay less tax and have more after-tax income in retirement.
Income Cap and Estate Planning:
The Roth IRA also has higher contribution limits than the traditional IRA for high-income earners. However, both types of IRAs are subject to different regulations and estate tax treatment. Traditional IRAs are subject to estate taxes at the death of the account holder and income taxes when funds are withdrawn. A Roth IRA reduces the taxable estate because the income tax is pre-paid.
In conclusion, the Taxpayer Relief Act of 1997 has offered an alternative way of saving for retirement, The Roth IRA, that provides different benefits than the traditional IRA. Both IRAs provide identical tax benefits, but the timing of the benefit differs between the two. The Roth IRA is an appealing option for many taxpayers, especially for those who expect to have a lower tax rate in retirement and for those who exceed the contribution limits for a traditional IRA. Both are subject to different regulations and estate tax treatment.