Opening an IRA is a great way to save for retirement, but the type of account you choose can have a huge impact on your finances both immediately and in the future. The problem, however, is that most Americans don't understand the key differences between the two most popular account types -- the traditional IRA and the Roth IRA. In a recent TIAA survey, 56% of Americans admitted to thinking that all IRAs are the same, but this couldn't be further from the truth.
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While traditional and Roth IRAs come with the same annual contribution limits (currently $5,500 a year for workers under 50 and $6,500 a year for those 50 and over), traditional IRA contributions are tax-deductible, whereas Roth contributions don't offer an immediate tax break. On the other hand, Roth IRA withdrawals are taken tax-free in retirement, whereas traditional IRA distributions are subject to ordinary income tax rates. Furthermore, while there are income limits that determine eligibility for a Roth IRA, anyone can contribute to a traditional IRA. It pays to familiarize yourself with the nuances of each account type so that you can make the best decision for your future.
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One major advantage of the traditional IRA is that contributions are tax-deductible the year you make them. Say your effective tax rate is 25% and you max out the $5,500 limit for your traditional IRA this year. You'll shave $1,375 off your 2017 tax bill, plus you'll get to benefit from tax-deferred growth on your account over time. See, when your investments in a traditional brokerage account earn money, you're required to pay taxes on those gains year after year. With a traditional IRA, you won't be subject to taxes on investment growth until the time comes to take withdrawals in retirement.
The money in your IRA can be withdrawn penalty-free once you reach the age of 59 1/2. Removing funds prior to that age could result in a 10% early withdrawal penalty unless you happen to qualify for an exception (such as if you're using the money to pay for college or purchase a first-time home). Once you retire and start taking money out of your account, your withdrawals will be subject to whatever your ordinary income tax rate is at the time. But if you're not planning to work in retirement, there's a good chance that tax rate will be lower than what it is today -- in which case you're better off paying taxes later in life.
One final thing to keep in mind about traditional IRAs is that they're subject to required minimum distributions (RMDs) once you reach age 70 1/2. Your exact RMD will depend on your life expectancy and account balance at the time, but if you fail to take it in full, you'll face a 50% penalty on whatever amount you neglect to withdraw. While some seniors don't mind RMDs, since they need the money anyway, if you have another source of income, RMDs can be both a hassle and a source of additional taxes -- which is why they're one drawback of traditional IRAs you ought to consider.
Though Roth IRA contributions aren't tax-deductible the year you make them, the good news is that your investments get to grow completely tax-free -- meaning, you'll never pay taxes on your earnings. Once you reach retirement, your withdrawals won't be taxed, which means however much money you have in your account is yours to utilize in full.
Roth IRAs also offer more flexibility than traditional IRAs in that withdrawals can be taken without penalty at any time provided you're only touching the portion of your account that represents your principal contributions. You may face an early withdrawal penalty if you remove the earnings portion of your account prior to age 59 1/2.
Furthermore, Roth IRAs don't impose RMDs, which means you can leave your money to sit and grow indefinitely. This can be a huge plus if you have other sources of retirement income and don't need to touch your Roth IRA for many years.
One major drawback of Roth IRAs is that they come with income limits. If you earn more than $132,000 as a single tax filer or more than $194,000 as a couple filing jointly, you won't be eligible to make direct contributions to a Roth. You will, however, have the option to convert your traditional IRA to a Roth account down the line.
Which IRA is right for you?
Because traditional and Roth IRAs both have their share of benefits and drawbacks, you may want to ask yourself the following questions to arrive at the best choice:
- Do I need additional tax breaks today? If so, a traditional IRA might be the way to go.
- When will my tax rate be at its highest? If you expect your tax rate to be higher in retirement, then it pays to choose a Roth. Also, because we don't know what tax rates will look like in the future, a Roth IRA protects you from a potential hike.
- Do I want more options for withdrawing my money? Roth IRAs offer the utmost flexibility with regard to withdrawals, but beware of the temptation to use that money for purposes other than retirement.
To further aid in the decision-making process, here's a table summarizing the ways traditional and Roth IRAs differ:
TABLE BY AUTHOR.
No matter which type of IRA you choose, the key is to start funding it as soon as possible. The more time you give your money to grow, the more savings you'll have available in retirement.
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