Traditional vs. Roth IRA: Understanding the Key Differences

Individual retirement accounts are classified in different ways for tax-recording purposes. Understand that the IRA is a tax-sheltered structure. It can hold funds already contributed into other retirement plans or it can accept contributions. As a structure, it has many investments you can buy within the account. The designation of Roth and traditional define the tax structure while contributory and rollover define how funds get into the account.

Traditional or Roth

There are two fundamental tax structures for IRA accounts. A traditional IRA structure deducts contributions from annual income and grows tax-deferred until it is distributed. Upon distribution, the amount withdrawn is added to annual income and taxed at the existing tax bracket of the IRA owner. A Roth IRA does not deduct contributions from the owner's annual income. Money does grow tax-deferred but as long as the account owner has the Roth IRA for at least five years and is at least 59 1/2 years of age, the money comes out tax-free. Both structures have a 10 percent tax penalty on distributions before age 59 1/2.

Contributory IRAs

Both of the IRA structures can be contributory IRAs. Essentially every IRA or retirement plan must start with contributions. A contribution is the money you put into the account based on your annual allotment. The 2011 maximum contribution into either a Roth or traditional IRA is $5,000 for those under age 50; those over the threshold can contribute $6,000. If you are able to make annual contributions into your IRA, it is a contributory IRA regardless of whether it is a traditional or Roth.

Rollover IRA

When a person has a 401k, 403b, IRA or other similar contributory retirement plan account that has accumulated funds over years of contributions, a rollover may become an option. A rollover moves funds from one retirement plan to another, often from an employer's plan to an IRA after the job terminates. The IRS defines rollover IRAs simply for tax recording. When the rollover happens, a 1099-R says how much goes out of the IRA and Form 5498 says how much went into the new rollover IRA as checks and balances that no distribution was made. A rollover IRA is generally not commingled with contributions.

Commingling Assets

The differentiation between a contributory IRA and a rollover IRA is generally maintained at the custodial level. The IRS maintains the accounting via the Form 1099-R and Form 5498 for all rollovers and uses your Line 32 deduction on Form 1040 to account for all tax-deducted contributions. It is up to your IRA custodian to allow or deny the commingling of assets contingent on their own administrative abilities to maintain proper accounting. While it may be convenient to roll a former employer plan into a commingled account, you lose the ability to roll the rollover assets into a new employer's plan if you commingle assets. For those who may want to keep this option, keeping contributory and rollover assets separated is the way to go.