You’re ready to establish a retirement savings account, and you want to go with the option that best fits your financial situation. Now you need some background information to determine whether a traditional IRA or Roth IRA is the right move for you.
To determine which is better we must start with the basics. The abbreviation IRA stands for Individual Retirement Account. Just about anyone can open and contribute to an IRA. To contribute to an IRA, you must earn an income. Traditional IRAs and Roth IRAs have many similarities, but there are distinct benefits to each.
We will outline the main differences between a traditional IRA and Roth IRA, and offer you the insight you need to choose the right option. While we will give you all the hard facts, you may want to consider the help of a financial planner to give you an outsider’s perspective of the account that will best support your financial future.
The IRS limits how much you can contribute to an IRA each year. Contribution limits for traditional and Roth IRAs are the same. In 2019, you could contribute up to a maximum of $6,000 total between all types of IRA accounts. If you’re over the age of 50 you can make an additional $1,000 catch-up contribution for a total of $7,000.
When you invest money in an IRA the funds you contribute grow over time. The amount of growth achieved depends on the investments you choose to hold in the account. Both traditional and Roth IRAs benefit from tax-deferred growth.
This means you won’t have to pay taxes every year on interest, dividends or capital gains like you would in a non-retirement account. This helps your investments grow even faster using compounding growth. Essentially, without the reduction of taxes, the amount of money in your account can grow faster and more rapidly, enabling you to maximize your savings.
Benefits of a traditional IRA
When you contribute money to a traditional IRA you’ll typically receive a tax deduction, dollar for dollar, up to the amount you contribute. For example, if you earn $50,000 and contribute the $6,000 maximum to your traditional IRA, when you file your taxes the deduction will make it so you only pay taxes on $44,500 of your income.
Therefore, the money you contributed to the IRA will not be subject to taxation, yet. The keyword here is “yet”. Instead, the IRS will collect their taxes later. When you take distributions from the account, after reaching age 59½, you will owe income taxes on every penny you withdraw, both contributions and growth.
Traditional IRA withdrawal rules
It’s called a “retirement” account for a reason – the money you’re saving is for use when you retire. That means, if you withdraw funds from a traditional IRA early (i.e.- before age 59½) the IRS will assess a 10% early withdrawal penalty. Don’t do that!
Benefits of a Roth IRA
In terms of taxes, the Roth IRA is the complete opposite of the traditional IRA. With a Roth IRA, you’ll benefit from taxes when you withdraw from the account in retirement, not when you put contribute. Using the same example as before, if you earn $50,000 and contribute the $6,000 maximum to your Roth IRA, you still pay income tax on the full $50,000 you earned that year.
Therefore, the money you contribute to a Roth IRA has already been subject to taxes. This means when you take distributions after age 59½, you pay nothing in taxes. Roth accounts are the only type of retirement savings that allow you to withdraw both contributions and growth tax-free.
Another feature that may appeal to potential savers is the penalties associated with withdrawing from a Roth IRA. Unlike a traditional IRA, if you withdraw from a Roth IRA (and this applies to simply what you’ve invested NOT any growth you’ve accumulated) you will not have to pay any taxes or an early withdrawal penalty. While we still don’t advise you do this, it may be a good thing to have in your back pocket in case of an emergency.
There are some restrictions to keep in mind
Earlier we mentioned you must have an earned income to make contributions to an IRA. This rule has only one exception and that is if you’re making contributions for a spouse or minor children. That said, if you earn too much income, the IRS may disqualify you from making direct Roth IRA contributions or being able to deduct traditional IRA contributions. These income thresholds change over time and you can see the most current numbers posted on the IRS website.
Which is better, the traditional or Roth IRA?
The answer to that question depends on your situation. There are great benefits to both. You’ll want to do your best to balance both of these tax benefits and determine the one that is most suitable for your long-term goals.
If you earn a fair amount of income and don’t have many deductions the traditional IRA may be best. That’s because getting a tax deduction in the current year will keep more money in your pocket and you’ll pay less income tax. But, if you have a longer time until you retire or you’re not concerned with current taxes, you may benefit more from the Roth IRA. Having retirement investments grow with compounding interest and not paying taxes when you withdraw funds is a compelling feature.
The bottom line
The good news is, no matter which you choose you’ve made a great decision because saving for retirement is always a good thing. You’ve already taken the most important step by determining your need to plan for your future. If you’re feeling like you want a knowledgeable guide, to help you make your choice, consider enlisting the assistance of a financial advisor. They can help you weigh your options and figure out the most effective method that aligns with your current financial situation and long-term retirement goals.