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When it comes to IRA discussions, there are two good solutions for those that qualify. The traditional IRA and the relatively new and frequently under-utilized Roth IRA are both available for most families. Though each is intended to be retirement savings, there are some big differences in how both account types will work.

Tax Deductible Contributions for the IRA

The first major difference in the two accounts is the tax treatment of contributions. When a family deposits money into a traditional IRA, the annual contribution CAN be tax deductible. The term ‘CAN’ is used because not everyone can deduct this and there are limits to the amounts.

Tax deductible simply means that a tax filer can reduce their taxable income by that amount. For example, a family that makes $80,000 per year might deposit $4,000 into each of their IRA’s. The deposits totaling $8,000 could reduce their taxable income to $72,000 therefore reducing their tax liability for the year. This is a nice benefit for the traditional IRA, but is ‘tax deductible’ better than ‘tax free’? More on this in the last section labeled ‘Pay Dirt’…

Unfortunately, contributions to a Roth IRA cannot be deducted on income tax filings. Any deposits the family makes into these accounts will have to come out of their after tax income. Don’t fret the Internal Revenue Service makes up for this minor pain with major benefits later in life.

Extras Available with the Roth IRA

The late William Roth, account namesake, left a number of beneficial provisions in his legislation that created the plan.  First, there are opportunities to withdraw funds for specific life events without paying the 10% penalty normally incurred for those less than fifty-nine and a half years old. Families can access the account toward the purchase of a first home. Additionally, the assets can be used to pay for college, though only for select members of the direct family.

Another seemingly inconsequential provision is that there are not mandatory distributions for Roth IRA owners at age Seventy and one half years of age. For me, this is a humorous attempt by Uncle Sam to pull one over on the populous, which I’ll clear up later in the article. However, if you don’t want to withdraw the money tax free, well, you won’t have to if it is held within a Roth IRA.

‘Pay Dirt’ for the Roth IRA

Here’s the biggest gift the IRS has ever given its citizens – distributions from a Roth IRA are almost always TAX FREE. Only life insurance proceeds, municipal bond interest, and Roth accounts can boast this wonderful benefit. This not only includes the money you put in (and already paid taxes on!), but the growth in the account is never taxed!

Consider the difference here between the traditional and Roth. The traditional gives a tax deduction for the relatively small contributions, in most cases we are talking about deposits of a few thousand dollars. So, the deductions might save a family hundreds or possibly $1,000 on their tax liability if they even have one. The Roth on the other hand will let the time value of the deposits pile up and let it be withdrawn TAX FREE later!

How much impact can this have? Let’s visit the earlier example of our family contributing to each type of account. Let’s say they deposit $8,000 each year for thirty years, earn a modest 6% return on investment, and that they will always pay an effective tax rate of 25%. The deduction savings in the traditional account would be $60,000 or $2,000 per year for thirty years ((8000 x .25 = 2000) x 30 = 60000).

Continuing our example, the account would grow to around $632,000, meaning they’d pay $158,000 in taxes if they withdrew it all during retirement. So, would you exchange $60k for $158k? We’d take that deal every day! Now, in the event that the $2,000 in savings makes or breaks the family budget during the early years then this logic doesn’t work. In any event, as the rate of return increases the overall tax savings of the Roth account also increase. The savings can be tremendous.

Don’t Ignore Distribution Planning

If it’s not clear, I’m a huge fan of the Roth IRA. Particularly for younger families that can reap huge rewards by starting early. The versatility of the account can help them through all the tougher phases of family life. During retirement, the emphasis is on replacing income previously supplied by the career. During this time the Roth IRA can really help to balance out income. It should be noted that younger families are more likely to qualify for Roth IRA’s as their income is normally lower at this stage.

To address my teaser from above, my advice for you and your spouse to take that money out tax free. Leaving that money for beneficiaries and even children just creates opportunities for Uncle Sam to take a bite out of it. Don’t withdraw every cent the year you turn sixty, but use the account freely to balance your income and reduce your income tax burden each year.

Collin Hedegard, RIA is a writer for the Mutual Fund Site.