- The difference between the Roth IRA and the traditional IRA is to choose whether you want to save now pre-tax or post-tax dollars for retirement.
- A traditional IRA lets you save pre-tax income and let the earnings grow tax-deferred. You contribute to your traditional IRA before you pay federal and state income taxes, and you pay taxes only when you make the required minimum distribution (RDMs) in retirement.
- A Roth IRA lets you save post-tax income and let the earnings grow tax-free. You contribute to your Roth IRA After you pay federal and state income taxes, and you pay no taxes if you keep the Roth for more than five years and no required minimum distribution (RDMs) in retirement.
- Visit the Financial Middle-Class homepage for more stories
The difference between the Roth IRA and the traditional IRA is to choose whether you want to save now pre-tax or post-tax dollars for retirement. Besides employer-sponsored 401(k), individual retirement accounts (IRAs) are the most convenient and tax-efficient way to put money away for retirement.
Many financial experts would even argue that an IRA is a better retirement saving vehicle than 401(k) because of its flexibility. However, we disagree because many 401(k) plans have an employer match.
An IRA is an account that holds your investments, but they do have numerous nuances of complexities. The goal of this article is to demystify those complexities.
What is an IRA
An individual retirement account that lets stash money away for retirement with tax-free growth or on a tax-deferred basis. You can open an IRA account with numerous financial institutions. However, it’s best to open your account with a reputable discount brokerage firm. They often have excellent customer support and low fees, and they give you access to low-cost investments. There are several types of IRAs, but Roth IRA and traditional IRA are the most commonly used.
Traditional IRA
A traditional IRA lets you save pre-tax income and let the earnings grow tax-deferred. You contribute to your traditional IRA before you pay federal and state income taxes, and you pay taxes only when you make the required minimum distribution (RDMs) in retirement.
How it works:
Traditional IRAs are attractive for high earners who want to reduce their current tax obligations. Your IRA contribution reduces your taxable income.
- Even if you have an employer-sponsored 401(k), you can contribute to a traditional IRA
- Anyone can contribute to a traditional IRA, but not everyone can deduct contributions.
- Investments grow tax-deferred; you’re not taxed on gains until you withdraw them.
- Early withdrawals may be taxed as income and assessed a 10% penalty.
Benefits of Traditional IRA:
Pros:
- You can open a traditional IRA regardless of your income level, but your deductions are limited.
- You can use traditional IRA money to pay for qualified college expenses without paying an early distribution penalty. However, you’ll pay taxes on the distribution.
- No required minimum distribution (RDM) until you are 72 years old
Cons:
- If you tap the money before age 59½, you’ll pay taxes and a 10% early distribution penalty unless your withdrawal qualifies as an exception.
- You must begin taking distributions called required minimum distributions at age 72.
- If a retirement plan covers you at work, your ability to deduct IRA contributions may be reduced or eliminated at higher incomes.
- No more stretch IRA, if your kids inherit your IRA, you must start taking RDMs 10 years after your death
ROTH IRA
A Roth IRA lets you save post-tax income and let the earnings grow tax-free. You contribute to your Roth IRA After you pay federal and state income taxes, and you pay no taxes if you keep the Roth for more than five years and no required minimum distribution (RDMs) in retirement.
How it works:
If you expect to be in a higher tax bracket in the future, a Roth IRA is ideal for you. If you are a top earner, you might not be eligible to open a Roth IRA since there are income limitations.
There are contribution limits $6,000 if you’re under age 50, $7,000 if you’re age 50 or older.
Benefits of Roth IRA:
Pros:
o No Required Minimum Distributions (RMDs)
o No contribution age restrictions
o No income taxes for inherited Roth IRAs
You can withdraw the money you contributed at any time without taxes or penalties.
Cons:
- If your tax bracket is lower in retirement, you will benefit more from a traditional IRA
- You pay your taxes upfront
- There are income limits
Both traditional and Roth IRAs are excellent retirement savings accounts. Depends on your income, you might not be able to open a Roth IRA. If you are eligible to open either one of them, you need to analyze your current financial situation and try to create a proforma personal balance sheet for yourself.
They both let you invest in mutual funds, stocks, bonds, exchange-traded funds (ETFs), and other financial assets. Roth IRA enables you to hold personal real estate, but a traditional IRA does not.
