As you start to save for retirement, you will need to choose between a traditional and Roth IRA. There are some big differences. We will help you study your options to make the best decision for your financial future.
An individual retirement account, or IRA, is a retirement plan managed by a financial institution or financial advisor. There are tax advantages involved in setting up and using an IRA. These benefits differ based on the type of IRA you choose.
A traditional IRA allows you to make contributions with money that you may be able to deduct on your tax return. Any earnings may be tax-deferred until you withdraw them in retirement. Here are a few features of traditional IRAs:
A Roth IRA allows you to make contributions with money on which you’ve already paid taxes. You can withdraw your contributions without any taxes or penalties, at any time and for any reason. Here are a few features of Roth IRAs:
What is the difference between a traditional IRA versus a Roth IRA? Let us break it down bit by bit.
Things to know:
Income limits are specific regarding a Roth IRA. In 2020, the upper limits are:
If you make any withdrawals to your IRA before you are 59 ½, you may have to pay taxes on your earnings, plus an additional 10% tax.
According to Investopedia, Qualified distributions from a Roth IRA are tax-free and penalty-free. A distribution is qualified if it’s been five years since you’ve contributed to a Roth IRA, and the withdrawal follows these guidelines:
Non-qualified distributions are any withdrawals that do not meet the guidelines above. In these cases, you will owe taxes at your regular income tax rate.
Things to know:
Contributions to a traditional IRA are usually made with after-tax money but may be tax-deductible if you meet the basic income requirements. Any potential earnings will be tax-deferred and are not taxed until you withdraw them after the age of 59½.
Anyone who is 18 or over with an income can have a traditional IRA. However, there are specific income limits for how much of your income may be tax-deductible.
If you make withdrawals before you are 59½, you may have to pay taxes on your earnings, plus an additional 10% tax.
Early distributions from traditional IRAs will most likely lead to hefty penalties. Contributions are made with pretax dollars subtracted from your taxable income for the year. This will reduce the amount of income tax you will owe. You will get a tax break upfront when you contribute towards your traditional IRA, but you will pay taxes on your withdrawals in retirement.
The main difference between Roth IRAs and traditional IRAs has to do with their tax advantages. With traditional IRAs, you deduct contributions now and pay taxes later. With Roth IRAs, you pay taxes on contributions now and get tax-free withdrawals later on. Be sure to look over your annual income and your tax bracket before deciding which IRA to choose.