Traditional IRA - Disadvantages

Disadvantages

• One must meet the eligibility requirements to qualify for tax benefits. If one is eligible for a retirement plan at work, one's income must be below a specific threshold for your filing status. If one's income (and thus tax rate) is that low, it might make more sense to pay taxes now (Roth IRA) rather than defer them (Traditional IRA).

• All withdrawals from a Traditional IRA are included in gross income and subject to federal income tax (with the exception of any nondeductible contributions; there is a formula for determining how much of a withdrawal is not subject to tax). If one's investment style is buy and hold (for very long time) or dividend-seeking, then a Traditional IRA may be at a disadvantage since holding stocks in an IRA means they lose their favorable tax treatment given to dividends and capital gains.

• If one has a lot of disposable income, a Roth IRA in effect shelters more assets from taxes on gains than a Traditional IRA does, because the contribution limits are the same, but the Traditional IRA is pre-tax, so it is equivalent to a lesser amount of Roth IRA money post-tax. Suppose someone in the 25% tax bracket has $5333 pre-tax income to invest. He can invest all of this post-tax (which is $4000) to a Roth IRA. But he can only invest a portion of it ($4000 pre-tax) to a Traditional IRA. In the future, again assuming 25% taxes, this will be equivalent to an initial post-tax investment of $3000. One would have to invest the remainder of the money that could not be contributed to the Traditional IRA to try to make up some of this difference; however, such an investment would not be tax-sheltered, so does not grow as fast as a tax-sheltered investment.

• Perhaps the greatest disadvantage of the Traditional IRA is its forced distributions based on age. Withdrawals must begin by age 70½ (more precisely, by April 1 of the calendar year after age 70½ is reached) according to a complicated formula. If an investor fails to make the required withdrawal, half of the mandatory amount will be confiscated automatically by the IRS. The Roth is completely free of these mandates.

• In addition to the distribution being included as taxable income, the IRS will also assess a 10% early distribution penalty if the participant is under age 59½. The IRS will waive this penalty with some exceptions, including first time home purchase (up to $10,000), higher education expenses, death, disability, unreimbursed medical expenses, health insurance, annuity payments and payments of IRS levies, all of which must meet certain stipulations.