The best time to start saving for retirement was yesterday. The good news is, the second best time is today. Whether retirement is in your near future, or still a way off, it’s a period of your life that is decades long—so you’ll want to be prepared. Fortunately, there are many ways to save efficiently and effectively. Today, we’re talking about IRAs, and how they can fit into your retirement strategy.
IRAs, or individual retirement accounts, are tax-advantaged accounts that help you save and invest for retirement. In short, IRAs can house a variety of financial products, such as stocks, bonds, exchange-traded funds, and mutual funds. While there are several types of IRAs, we’re going to focus specifically on the differences between a Traditional IRA and a Roth IRA, two of the more popular options.
The Traditional IRA
While IRAs are tax-advantaged, there are differences in those specific advantages. For starters, contributions to a Traditional IRA are tax-deferred. This means that the IRS will not count the dollar amount you contribute to your IRA as taxable income in that year. However, you will have to pay taxes when you withdraw that money in retirement.
Although the deduction sounds appealing at first, it’s important to note that depending on your income and filing status, you may not be able to take the full deduction. If you have a higher income, you may not be able to take the deduction at all.
The maximum annual contribution you can make is $6,000 if you’re under 50, or $7,000 if you’re older than 50. At the age of 72, you’ll be required to begin making withdrawals, if you haven’t yet. These are called Required Minimum Distributions (RMDs), and the minimums are based on the size of your account and life expectancy. If you do not take these distributions, you can get hit with penalties—sometimes up to 50% of your RMD.
The Roth IRA
The key difference between a Roth IRA and a Traditional IRA is that contributions to a Roth IRA are not tax deferred. This means that you won’t receive a deduction or credit for your contribution. However, this allows your qualified distributions in retirement to be tax-free.
Roth IRAs do not have RMDs, so you can make withdrawals when you want them, and you can continue to make contributions regardless of your age.
While contribution limits are the same as a Traditional IRA–$6,000 and $7,000—there are other limitations. The Traditional IRA limits the tax deduction based on income and filing statue, while the Roth IRA limits contributions based on those criteria. This means that high earners may only be allowed reduced contributions, or no contributions at all.
The Pros and Cons of a Traditional IRA
The advantages of opening a Traditional IRA include tax benefits now, which can be great for those looking to reduce their tax liability. Another advantage is that anyone can contribute to a Traditional IRA, meaning that you can work with a broker if your company doesn’t offer its own benefits. Lastly, a Traditional IRA offers tax deferred growth. This means that while in the account, no taxes need to be paid on dividends or capital gains—however, you’ll pay income tax on the distributions.
The disadvantages of a Traditional IRA include the taxes you’ll pay on distribution. The downside is that you cannot predict what tax brackets will be several decades into the future, so you could be liable for higher tax payments in retirement. RMDs can also be a disadvantage if you don’t need access to the money, and would rather allow the account to sit and keep earning. Finally, there are disadvantageous penalties for a Traditional IRA, including failure to take RMDs or taking a withdrawal before age 59 1/2.
The Pros and Cons of a Roth IRA
One of the greatest advantages of the Roth IRA is tax-free distributions. Because you pay taxes on the money you contribute, you’re allowed to enjoy the growth tax-free. That means you won’t have to worry about taxes increased by the time you retire. Another advantage is the lack of RMDs—so you can allow the money to keep growing if you don’t need to access it. And finally, a Roth IRA has tax-free growth.
An obvious disadvantage of the Roth IRA is that you don’t get deductions on contributions—so it won’t help you reduce a large tax bill in the present. Like a Traditional IRA, there are also penalties for accessing the money before age 59 1/2. In both cases, this is often a penalty of 10%, on top of any taxes owed. Another downside is that if you earn a higher income, you may not be able to max out your contributions, or in some cases even be eligible at all.
What’s Right for You?
When deciding between a Traditional IRA and a Roth IRA, it’s important to consider how it will fit into your personal economy. What sort of tax benefits are you looking for? And is it more important for you to pay taxes now, or later? You’ll also want to look at your income and filing status—this can affect whether you’re eligible to max contributions on a Roth IRA, or how much of your contributions you can deduct on a Traditional IRA.
If you’re looking to save on taxes now, and have a healthy retirement portfolio, you may be best suited for a Traditional IRA. If you’re seeking to maximize your retirement income, and can pay taxes now, a Roth IRA may be best.