Company pensions have become a relic, and the Social Security safety net seems to get thinner every few years. In preparation, we need to build our retirement plans using tools such as Individual Retirement Accounts (IRAs) along with 401(k)s from work.
Opening the right kind of IRA — traditional or Roth — can make a huge difference in your financial life, both now and in the future.
A Traditional IRA vs. a Roth IRA: Everything You Need to Know
Traditional IRAs and Roth IRAs are both individual accounts that offer different tax benefits to people for retirement. In order to make a regular contribution to either IRAs, you must have sufficient qualifying, earned income.
Contributions that are made to traditional IRAs are made on a pre-tax basis. This allows your money to grow tax-deferred in the account until you begin taking distributions.
When you contribute money to a Roth IRA, your contributions are made after you have already been taxed. Your money can then grow in the account.
When you retire, your distributions from a Roth account will not be taxed since the taxes were paid at the time that you contributed money to your Roth. These two types of accounts offer benefits to individuals who are wanting to save money for when they retire.
What is a Traditional IRA?
A traditional IRA is a tax-advantaged retirement account that allows you to save money and to grow on a tax-deferred basis. People are able to contribute up to $6,500 per year to a traditional IRA annually when they are younger than age 50. After they are 50, they can contribute $7,500 per year.
People who contribute money to traditional IRAs are able to claim deductions on their taxes during the year in which the contributions are made as long as the investors are eligible.
You cannot withdraw money from the account before you reach age 59 1/2, or you will face a 10 percent penalty. There are a few exceptions to the early withdrawal rule, however.
When you begin taking distributions from your traditional IRA, you will be taxed at your ordinary income tax rate at the time that you make the withdrawals. You must begin withdrawing money from your traditional IRA once you reach age 73, in 2023. And beginning in 2033, the distributions must begin at age 75.
What is a Roth IRA?
A Roth IRA is another type of IRA that has a few important differences from a traditional IRA. When you compare a traditional IRA to a Roth IRA, one of the first differences that will be apparent is that contributions that you make to a Roth IRA are made with after tax money while those that are made to a traditional IRA are made before taxes are paid. This difference means a couple of things.
While you can deduct contributions to a traditional IRA, you cannot deduct contributions that you make to a Roth IRA. Unlike a traditional IRA, you are able to withdraw your principal from your Roth account before age 59 1/2 without penalty. However, you will face a penalty if you withdraw the interest (or any gains) that you have earned.
Since you pay taxes at the time that you make contributions to your Roth account, you will not pay taxes when you begin taking withdrawals after you retire. There are no distributions required from a Roth IRA.
Traditional IRA vs Roth IRA trends
According to the Investment Company Institute , the average balance that people held in IRA accounts at the end of 2015 was $99,017. People who had Roth IRAs were likely to make contributions to the accounts.
Among people who held IRAs, 26 percent of those with Roth IRAs made contributions as compared to 6.5 percent who made contributions to traditional IRAs. A little less than 12 percent of the IRAs in the study received contributions during the year, and nearly 24 percent of people who had these types of accounts took withdrawals from them.
One important thing to note is that experts recommend that people save approximately 20 times their annual incomes for when they retire. The average IRA balance that was found by EBRI indicates that many people fail to save enough money.
Retirement planning should be something that people begin when they are young so that saving can become a lifelong habit.
Why are the differences between a traditional IRA vs Roth IRA important?
The differences between a traditional IRA vs Roth IRA are important to understand for a few different reasons. These accounts offer different tax benefits. Roth IRAs also have income limits, and traditional IRAs have maximum age limits.
Understanding the differences between a traditional IRA vs Roth IRA can help you to determine which of these two types of accounts might be better for you.
Some people might want to have both types of accounts so that they can take advantage of the tax deductions from a traditional IRA and the tax-free withdrawals from a Roth IRA.
Other Key Differences Between Roth & Traditional IRAs
Your IRA tax break isn’t the only difference between traditional and Roth IRAs. Here are some other key differences to know about:
Age Restrictions
Once you reach age 70-½, you can no longer contribute to a traditional IRA. A Roth IRA has no age restrictions for contributions. However, your contributions cannot be greater than your earned income for the year. You can continue contributing even while you’re withdrawing.
Anyone who earns an income is old enough to contribute to either kind of IRA, and only earned income from a job can be deposited into an IRA. You can’t deposit money you earned from selling property or stocks, for example.
Income Restrictions
Traditional IRAs have no income restrictions. Anyone can open a traditional IRA. Roth IRAs have upper-income limits. Currently, if you make more than $137,000 a year, you can’t open a Roth IRA.
A couple filing a joint tax return can’t open a Roth IRA if they earn more than $203,000 a year. These numbers usually increase by a few thousand dollars each year.
Mandatory Withdrawals
Traditional IRAs require you to make a minimum withdrawal each year after you reach age 73 and stop contributing to the account at 70 1/2. The amount you must withdraw depends on the size of your account and your income.
You will be taxed on these withdrawals since traditional IRA withdrawals are not tax-free.
Roth IRAs do not mandate withdrawals of any amount at any time. In fact, you can keep the money in the account until you die and let your heirs withdraw the funds or roll them into their own IRAs.
Early Withdrawal Penalties
In most cases, the IRS charges a 10 percent penalty to withdraw money from a traditional IRA if you’re younger than 59-½. This penalty will be assessed on top of income taxes on the withdrawn sum.
Since Roth IRA money has already been taxed, you won’t be taxed on early withdrawals of your contributions, but you will face the 10-percent penalty if you withdraw any gains before you reach age 59-½.
The IRS allows certain exceptions from early withdrawal penalties, such as financial hardship. You can also withdraw up to $10,000 penalty-free if you’re using the money to buy your first home.
Eligibility
Individuals may open traditional IRAs, and there are no minimum age requirements or maximum income limits. However, you have to be younger than age 70 1/2 to open a traditional IRA, and you cannot make contributions to a traditional IRA after you reach age 70 1/2.
Individuals also are able to open and contribute to Roth IRAs if they are eligible. Roth IRAs have maximum income limits. The phaseout of maximum Roth IRA contributions for single people begins at $122,000 with a maximum income limit of $137,000.
For people who are married, the phaseout for maximum Roth IRA contributions begins at $193,000 with a maximum income limit of $203,000.
Contribution limitations
There are annual contribution limits for Roth IRAs and traditional IRAs. People who are younger than 50 can contribute a maximum of $6,500 per year to either type of account. People who are 50 or older are able to make catch-up contributions of an additional $1,000 per year for a total of $7,500 per year.
If you have both a traditional IRA and a Roth IRA, your total contributions to the accounts must be the maximum contribution or less. You cannot contribute the maximum annual contribution amount to both accounts. Something that is important to note is that rollovers do not count towards the annual contribution limit.
Taxes and deductions
When you compare a traditional IRA to a Roth IRA, you will notice that there are different tax benefits of the accounts. Money that is contributed to a traditional IRA goes in on a pre-tax basis. This allows your savings to grow tax-deferred, but you will pay taxes when you start making withdrawals at your ordinary tax rate.
A traditional IRA and Roth IRA comparison also reveals that contributions that are made to Roth IRAs are made after taxes are paid. This means that you will not pay taxes at the time of disbursement after you retire.
Contributions that you make to a traditional IRA may be deducted during the years in which they are made if you are otherwise eligible. Contributions that you make to a Roth IRA cannot be deducted on your tax return.
Should I Open A Roth Or Traditional IRA?
If you want the short and simple answer, open a Roth IRA and try to deposit as much as the IRS allows each year, which is currently $6,500. Your money will grow tax-deferred, and you’ll have an easier time withdrawing money later if necessary when compared to a traditional IRA.
If you are concerned primarily with reducing your taxes today, and you don’t mind sharing the growth of your traditional IRA with Uncle Sam, then the traditional IRA may make sense for you.
During retirement, you’ll be able to withdraw money from the Roth IRA without paying income tax on the funds. But a Roth IRA won’t always be the best fit.
Both kinds of IRAs can help you maximize your retirement investing.
Can You Have Both A Traditional And Roth IRA?
Yes, you could open both a traditional and a Roth IRA, assuming you meet the age and income requirements of both kinds of accounts described above.
But there is a catch: Your maximum amount in tax-advantaged contributions each year will not increase. You’d just be splitting your maximum contribution — currently $6,500 — between two (or more) different accounts.
Is it Smart to Have Both a Traditional IRA and a Roth IRA?
Contributing to both a traditional and a Roth IRA has its advantages. None of us can be sure how our tax situation will look in 30 or 40 years. Having investments growing in both kinds of IRAs could give you more choices later in life.
You’d also have more flexibility. For example, what if you took on a part-time job in your 70s and started to earn more income? Or what if you started a consulting business and faced self-employment income taxes?
In those cases, you may find yourself in need of the tax break you’d get withdrawing money from your Roth rather than your traditional IRA account.
You’d still have to make minimum withdrawals from your traditional IRA based on current law. But at least you’d have a little more control over your tax picture.
Converting A Traditional IRA To A Roth IRA
If you have a traditional IRA and you’d prefer a Roth IRA, you can convert your IRA to Roth. However, doing this can have a significant impact on this year’s taxes since your earnings within the IRA would be considered taxable income.
If you recently opened the traditional IRA and would like to convert, your earnings may not be significant enough to cause trouble. Either way, I’d work with a tax professional to make sure you don’t wind up in a tight spot when you file your return.
IRA Or 401(K) — Which Is Better?
If your employer has a 401(k) program or something similar, like a 403(b), and they provide a company match, you should contribute to your employer’s plan before funding either kind of IRA. This employee match is essentially free money, and it definitely makes sense to take advantage of free money!
Employer-sponsored 401(k)s work a lot like traditional IRAs except your 401(k) may have limited choices for your investments. Your 401(k) contribution limits will be several times higher with your 401(k), leading to more tax relief.
When you change jobs, you typically have the option to roll over your 401(k) money into your new employer’s 401 (k) program or into your IRA.
Also, be aware that the IRS rules periodically adjust the contribution amounts based on your filing status and income. Be sure to verify the current rules prior to contributing to any of your retirement accounts.
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