Understanding the difference between a traditional IRA and a Roth IRA can help you decide which better fits your investment needs.
An IRA, or individual retirement account, is a retirement plan with certain tax advantages. There are a few types of IRAs, but we’ll focus on the two most popular: the traditional IRA and the Roth IRA.
Created in 1975, traditional IRAs can be opened by anyone, and your contributions are tax deductible. There are, however, certain requirements for the tax deductibility, based on your filing status, income and any other retirement plans you have. While your money is in the account, you are not taxed on it, but once you remove it from the IRA, you will have to pay federal income tax and gains tax on any profit you have made.
The benefit of a traditional IRA is the ability to deduct it from your taxes. Also, because you will presumably fall into a lower income tax bracket once you retire and will able to claim more and pay less in taxes, the traditional provides more benefit.
There are a few drawbacks, one of which is the eligibility to qualify for tax deductions. If you have a large amount of disposable income, a Roth IRA may be better as it protects your money from taxes on gains better than a traditional. Once you turn 70.5, you are forced to take money out of your traditional IRA, which many see as a drawback. Likewise, if you are under 59.5 years old, there is a 10% penalty for early withdrawal from your account.
The Roth IRA has a few more requirements for opening an account. Your adjusted gross income must be below $110,000 if you’re single or $160,000 if you’re married and filing jointly. Your contributions are not tax deductible, but there are certain things you can withdraw your money for without taking the early penalty or paying taxes, such as buying your first home.
You can contribute to your Roth IRA even if you also contribute to a 401k, unlike with a traditional IRA. You are never required to take distributions at any age, so if you want to keep your money and leave it to your heirs, you can do so in your Roth without tax penalties or other fees.
The main drawback to a Roth IRA is that contributions are not tax deductible. If you’re in a higher tax bracket, you’ll pay more income tax on your Roth. And there is some discussion that Congress might change the ability to take tax-free withdrawals from your Roth IRA, so that is a risk if you go with a Roth.
Examining the Two
If you’re trying to determine whether you should go with a regular IRA or Roth IRA, determine what’s most important to you. Would you rather realize instant tax benefits with a regular, or is it more important that you be able to take out your money without paying taxes on it later, and with no requirements to ever take it out if you don’t want to?
When you die, a Roth IRA can be transferred to your spouse and/or combined with his IRA, so consider that as well as any family circumstances you have. If you want to leave money to your heirs, a Roth IRA makes it easier to do so without penalty.
The key is to have some sort of an investment and retirement account so that when you do retire, you have money to cover your living expenses, as well as any health related costs you may incur. Do your research and speak to a financial planner to determine which type of IRA is best for you.