Is one type of account better than the other? How does each affect your taxes, now and in the future? And how will they affect the amount of money you’ll actually get to use when you retire?
What’s a traditional IRA?
A traditional IRA is an investment account designed to help people save money for retirement. It allows you to deposit money and grow that money on a tax deferred basis.
What that means is you don’t need to pay income tax on the money deposited into the account. And you won’t have to pay capital gains tax on any money that you earn in the account.
As of this year, you can contribute up to $5,500 per year, or up to $6,500 if you are age 50 or older. This assumes that you earned at least that much during the previous year. Also, depending on your income level, you may be able to deduct your traditional IRA contribution from your taxes.
NOTE: There is an important exception for how much you can deduct. Basically, if you are covered by a work plan, then your deductions may be limited by high income and marital status.
But even if you’re covered, don’t think that you never have to pay taxes. (Wouldn’t THAT be nice.) When you withdraw money from your account, you’ll have to pay income taxes at the rate in effect at the time of withdrawal. Your income at that time (which most likely will be lower than now) will determine that rate.
Since an IRA is meant for retirement savings, you will be penalized for withdrawing money early from your account. You have to pay taxes on any money withdrawn before age 59 ½. You’ll also have to pay an additional 10% penalty on that amount.
The penalty has some exceptions. If you withdraw money from your traditional IRA account due to disability, to pay for higher education, for certain medical expenses, or to buy a new home (up to $10,000 if you meet requirements), you are excluded from the penalty. You would still have to pay regular income taxes on the amount.
Required minimum distributions
On the flip side, once you reach age 70 ½, you will be required to withdraw a minimum amount from your account each year. There are a number of factors, including your account balance, that will determine the exact amount. If you fail to withdraw that amount, you will be subject to an IRS penalty of 50% of the amount you were required to withdraw.
What’s a Roth IRA?
A Roth IRA is also designed for retirement savings. You can invest in the same products available for a traditional IRA, and the yearly contribution limit is currently also $5,500, or $6,500 for age 50 or older. In order to be eligible for a Roth IRA, however, your adjusted gross income must be less than $117,000 for a single tax filer and $132,000 for a joint filer.
Also, there is a big difference between a traditional and a Roth IRA when it comes to taxes. Unlike a traditional IRA, a Roth IRA requires you to pay income taxes on the money that you deposit. On the other hand, you do not have to pay any taxes on the money when it is withdrawn from your account. For some, that’s a big plus.
You can also withdraw your deposit amount (but not any money that you have earned in the account) at any time without paying taxes or penalties. Just like a traditional IRA, there are no capital gains taxes for any money that you earn in your account.
In addition, a Roth IRA has no required distributions at any time. You can leave all of the money in your Roth account as long as you like, even after you reach age 70 ½.
Quick comparison of Roth IRA vs Traditional IRA
Summary of similarities:
• Tax advantages compared to a regular savings account
• Allow for investment in many different investment products
• Easy to open
• Current annual contribution up to $5,500 ($6,500 age 50 or older)
Summary of differences:
|• Pre-tax dollars||• After-tax dollars|
|• Required Minimum Distributions (RMD)||• No RMD|
|• Early withdrawal penalty and back taxes on any early withdrawal||• No penalty or taxes on early withdrawal of principal|
|• Contributions often tax deductible||• Roth: Contributions not tax deductible|
Roth IRA vs Traditional IRA: Which will get me more when I retire?
That depends. If you aren’t earning a significant amount of money right now, the Roth IRA is probably better for you. You’ll pay a small amount of taxes right now, and you won’t have to worry about the taxes when you retire. At that point, you may or may not be earning more money. (Some folks still work, of course, by choice or otherwise.)
Then again, if you currently have high earnings, you might instead want a traditional IRA (to the extent you qualify). You won’t pay taxes now, and you most likely will be in a lower tax bracket when you finally do retire, especially if you’re not working.
Some people prefer a compromise position. So they put money into a traditional IRA to get the deduction now (especially if it lowers your tax bracket). But, if they have enough money, they also invest in a non-retirement account. Just remember, when you finally need to use that money there will be a tax bite on your traditional IRA!
Which types of investments are best for each type?
An IRA allows you to invest in many products, including stocks, bonds, mutual funds, and ETFs (exchange-traded funds). The exact options will depend upon the financial institution where you open your account.
In general, both types of IRAs come with equal investment choices. Stocks and stock mutual funds offer greater opportunity for significant long term gains, but at a greater risk. The general rule is the younger you are, the greater percentage of your money should be invested in stocks, as you can afford to take greater risks since retirement is further away.
Bonds offer fixed rates of return you can count on, but historically offer lower returns than stocks over time. The closer you are to retirement, the more you may want to have invested in bonds. Just remember — you won’t need all your money at once, so if there are stocks and stock funds in your portfolio and the market is diving, you can leave them untouched until markets recover.
A few cautions
Medium and especially long term bond funds have the potential for significant losses. And they are not as safe as individual bonds that have maturity dates, where you get every penny of the face value back, in addition to all you’ve earned over time.
Also, avoid tax-free bonds and bond funds in an IRA, as you already are exempt from current taxes since you hold your investments in an IRA.
Remember to always check for fees and hidden costs. Ask whether the investments you choose have any fees / loads. And, if you’re paying commission, ask how much you’re paying.
What’s the cost to you for investing?
There are some financial institutions (not all) that charge fees for opening accounts and / or managing them yearly. Many of them also only offer what we call “load” funds, meaning you may pay a hefty percentage to purchase them. Make sure to ask about all that so you know upfront what working with them is costing you.
Certain online brokers like Fidelity, Vanguard, T. Rowe Price, etc. may be a good alternative. They offer money-saving alternatives like very low trading fees for buying stocks, lots of quality “no-load” funds that don’t cost you anything to purchase, and no-annual-fee management of accounts. [Always research anything you are thinking about buying.]
Many banks also offer no-annual-fee management, but you should still compare their trading fees with other financial institutions to see where your banks stands. Also, to help pay for the financial advice your representative offers you for free, banks commonly only offer funds that charge a load. Again, just get the facts, and then decide what works best for you.
Can I contribute to both types of IRAs in same year?
You certainly can, but you can’t double dip. That means that your combined contributions can not be more than the $5,500 (or $6,500 after age 50) yearly limit. For example, if you contribute $3,000 to a Roth IRA, you could only contribute $2,500 to a traditional IRA for that year.
Note: Check for exact maximum contribution levels each year since the yearly limits change.
How to start a Roth or Traditional IRA
Opening an IRA of either type is pretty simple. You can do so with almost any financial institution, such as banks, brokerages houses, or online brokers such as Fidelity, Vanguard, T. Rowe Price, (along with many others). It just takes filling out a few forms.
If you already have a broker you trust, you can ask them for help opening a retirement account and possibly to discuss which type of IRA may be best for you. Again, remember to ask about what it will cost you — and do your own research on any investments you are considering.
For most of us, a comfortable retirement means that we have enough money to support us whether or not we still choose to work. This means not only making it a habit to tuck away enough money for those later years, but managing what you do have wisely.
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