If you're trying to save money for retirement, you're probably familiar with IRAs - individual retirement accounts. IRAs come in two flavors: traditional and Roth. Both can help you save for retirement, but there are some crucial differences between traditional IRAs and Roth IRAs.
We'll get into the details of their differences and similarities below. First, though, let's talk about how IRAs matter to your life plan.
Both kinds of IRAs have the same basic goal: Provide income to you after you retire. They can create the foundation for your future nest egg, so you don't have to worry when you're ready to stop working.
To that end, both types of IRAs let your money grow tax-deferred. That means you don’t pay taxes on earnings as you earn them, like you would in a non-retirement investment account.
Why does that matter? Without the constant tax drag, your money can grow faster than it would otherwise.
For example, if you earned $500 in dividends in a regular non-retirement investment account, you'd pay tax on those dividends now. But if you earned those dividends in any kind of IRA, you skip that current tax bill.
Another similarity: Both allow for catch-up contributions as soon as you reach age 50. That lets you sock away a little extra tax-advantaged money every year as you near retirement age.
Other than a few special rules that apply to both, like penalty-free $10,000 withdrawals for first-time homebuyers, that's really where the similarities end.
The differences between traditional and Roth IRAs center around taxes and the ability to access your money. Here are the five main differences between the two:
How can you tell which is better for you? It depends on your current situation and your future expected situation.
My take: Go Roth whenever you can. Tax-free earnings win with me, hands down. Access to the your own money without tax penalties, check. And not being forced to take money out if you don't want to - perfect.
But your choice may not be that simple.
The old rule of thumb was to guess at the expected tax rate when you eventually retire. If you expected your tax rates to be lower when you retired, a traditional IRA was the better choice. But if you thought your tax rate would be the same or higher, a Roth IRA made more sense.
Now, with tax laws changing all the time, it's anyone's guess what the future will hold. That's why many people focus on the current tax deduction when making their choice.
Again, this is all based on current tax law, which can change at any time. But we only know what we know, and make the best choices we can based on the information we have.
|Feature||Traditional IRA||Roth IRA|
|Maximum contributions for 2021 and 2022||$6,000
$7,000 if you’re over 50
$7,000 if you’re over 50
|Contribution limits||N/A||Yes, based on income|
|Deduction limits||Depends if you (or your spouse) can contribute to a retirement plan through your job||N/A, all contributions are taxable|
|When can you take money out without penalty?||Beginning at age 59½||Contributions: Any time
Earnings: 5 years after the first contribution is made and at/after age 59½
|Earnings taxed?||Tax-deferred||Tax-free in most circumstances|
|Required minimum distributions?||Yes, starting at age 72||None (unless the account holder dies)|
For more detailed information about Roth IRAs and taxes, click here.
For more detailed information about traditional IRAs, penalties, and taxes, click here.
Those links come with a BORING WARNING, but the information is 100% reliable.
Not sure which kind of IRA is best for you? Contact me here to set up a free consultation and we'll figure it out together.