Define Individual Retirement Account

Traditional vs. Roth

The typical person considering an IRA will choose between a traditional IRA and a Roth IRA. The main difference lies in when the account holder pays taxes. With a traditional IRA, contributions you make to the account are tax-deductible. Then, when you withdraw money later on, you will pay income taxes on the distributions. In a Roth IRA, contributions are not tax-deductible, but when you take money out of the plan later on, you don't have to pay any income tax on it. The advantage of the Roth IRA is that money you make from your investments in the plan is untaxed.

Anyone who has taxable compensation and will not turn 70 ½ by the end of the year can set up a Traditional IRA. The Internal Revenue Service defines taxable compensation as wages, salaries, tips, commissions and bonuses, plus alimony payments. If your only income is non-compensation income -- such as dividends, interest, rent or royalty payments, or investment profits -- then you're not eligible to contribute to a Traditional IRA. If you are eligible to participate in a retirement plan offered by your employer, you may not be able to fully deduct your contributions to a traditional IRA.

A Roth IRA, however, does have income limitations. A married couple with a modified adjusted gross income of $169,000 or lower can contribute the maximum amount to a Roth IRA. A single person with a MAGI of $107,000 or less can contribute the maximum to a Roth IRA. Married individuals living separately need a MAGI less than $10,000 to fully contribute.

Once you open an IRA, you can't contribute an unlimited amount. Tax law sets an annual contribution limit, which rises with inflation; as of 2010, that limit was $5,000 a year, or your total taxable compensation, whichever is less. If you are at least 50 years old, you can put in an extra $1,000 a year as a "catch-up" contribution. There's no minimum annual contribution.

You can begin withdrawing money from your IRA at age 59 1/2. If you have a traditional IRA, you must start withdrawals in the year you turn 70 1/2. After that age, the minimum amount you have to take out every year is based on your age -- really, your life expectancy -- and the amount of money in the account. If you have a Roth IRA, however, you aren't required to take any money out. You can die and pass the whole thing to your heirs, if that's your plan. Why the difference? With the traditional IRA, you've deferred the taxes, and the government wants to ensure that you pay those taxes at some point. With a Roth IRA, the taxes are already paid.

You can take money out of a Traditional IRA before you turn 59 1/2, but it will cost you. In addition to any income taxes you have to pay on the withdrawal itself, the IRS adds an additional tax of 10 percent of the total amount withdrawn. The 10 percent penalty applies to traditional IRA withdrawals. The IRS waives the penalty in certain circumstances, including if you become disabled, if you need the money for a down payment on a house, or if you need to pay large medical bills. A Roth IRA allows regular contributions to be withdrawn before 59 ½ income tax and penalty free. Taxes and penalties may apply for non-qualified Roth IRA distributions of earnings.