Are you interested in putting money into an individual retirement account, but are unsure whether to go the traditional or Roth IRA route?
This is a big decision with more implications today and down the road than you might think. These two IRAs come with significant differences that will affect your taxable income when you invest, as well as when you retire or chose to withdraw.
The key difference between a traditional and Roth IRA is that contributions to the Roth IRA are not tax deductible. You pay taxes on your Roth contributions now, as opposed to a traditional IRA, where contributions are tax deferred, so you pay your taxes at the time of withdrawal.
The reason both IRAs still exist is that different investors – depending on age, other assets and net worth – have found different IRAs to be most beneficial.
The important thing is to not automatically dismiss the Roth IRA because it taxes your contributions. The upside to this approach is not only that you’ll be able to withdrawal tax free later, but that because you’ve already paid taxes, you’ll have a more realistic sense of your total holdings.
Another big difference is that it’s generally easier to take money out of a Roth IRA without paying a penalty. Direct contributions to your Roth IRA can be withdrawn at any time without penalty or taxes, and earnings on your Roth can also be withdrawn tax free after five years if you are at least 59 ½. By contrast, withdrawals from your traditional IRA are taxable and also subject to an additional penalty if you take the money out before age 59 ½.
Again, both structures may benefit different investors, but the key thing to keep in mind regarding when and how you can withdraw your money is that it’s a lot easier to take your money out of the Roth IRA before retirement without paying a penalty.
Beyond those two key distinctions, there are a host of other rules covering eligibility and contribution limits that each investor should carefully consider to decide whether you qualify for one or both IRAs, and which one will benefit you most. In short, read all the fine print to avoid being blindsided in the future. Some key things to consider include:
- Your other retirement contributions. Because a traditional IRA is most similar to the traditional employer-sponsored 401(k), the Roth IRA may be more appealing to investors who are employed and already saving through a 401(k). It provides another means to contribute to retirement, but also offers a way to take your money out early if needed. If you’re on the younger side and trying to also save for things that will come before retirement, like a house or your child’s education, a Roth IRA can be a good way to save without committing to lock that money away until you’re almost 60.
- Your tolerance for complexity. It’s never advisable to just invest and forget about it, but if you tend to like low-maintenance investments, you might well be drawn to the Roth. Because contributions are taxed up front, you won’t have to worry about taxes on future withdrawals. You also won’t have to worry about a series of required withdrawals from a traditional IRA that start when you’re 70 ½. And, because you’ve already paid taxes on a Roth IRA, you won’t have to calculate total versus actual, after-tax savings the way you will with a traditional IRA.
- Your future tax bracket. Many investors move into a lower tax bracket when income declines in retirement, and for this reason they prefer deferring taxes on investments. Here’s where the traditional IRA can make a lot of sense. Even if you do have to pay taxes later, your tax bill may wind up being a lot lower than it would be in your peak earnings years.
- Your commitment to save for retirement. For all the limitations that come with penalties for early withdrawals, there is one big upside: it helps you meet your retirement goals. In terms of providing the discipline to save for the long haul, few tools can beat the traditional IRA or 401(k), which make it very hard to take your money out early. If you’re an investor who has trouble saving on your own, or if you’re self-employed or otherwise restricted from investing in a 401(k), the traditional IRA may be just the vehicle you need to build a nest egg.
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