When you’re planning for retirement and looking at which types of IRA to get, it’s important to know the difference between various types with regard to how they’re funded and how they will be taxed when you’re ready to withdraw money. Let’s compare a Roth IRA to a traditional IRA on four important areas.
- A Roth IRA is always funded with after-tax dollars. Plus earnings on your investments grow tax-free. This means that if you retired and withdrew all of your money from a Roth IRA, assuming you are over the age of 59½, there would be no taxes on your gains, nor on your principal.
- A traditional IRA can be funded by either pre-tax or after-tax dollars, depending upon your level of income. This means that you might possibly reduce your income taxes now by contributing to the IRA. However, a traditional IRA is considered tax deferred – i.e. you pay taxes when you take distributions in retirement or if you make withdrawals prior to retirement.
Both traditional and Roth IRAs come with eligibility rules and restrictions that determine how much you can contribute. For both retirement plans, you are eligible to contribute up to $5,500, or $6,500 if you are age 50 and over.
- Traditional IRAs have no income restrictions but your income can affect how much of your IRA contribution you’re allowed to deduct, if any, from your taxes.
- Roth IRA contribution limits are based on household income and those at higher incomes often find themselves either partially eligible or not at all.
Note : If you are single, you have to have earned income in order to contribute to either a Roth or a traditional IRA. If you are married and one spouse has earned income then the non-working spouse can contribute to either.
With a traditional IRA, you are subject to taking required minimum distributions at age 70½ for the account owner. So, there is that ongoing ‘maintenance’ with a regular IRA, in which you’ll be required to take a portion of your IRA out regularly in your golden years, with taxes paid on those required distributions. Plus if you are over 70½, you cannot make contributions to a traditional IRA.*
* Note: There are exceptions. Please contact your financial advisor for details.
With a Roth IRA, there are no minimum distributions beginning at age 70½ for the account owner. If you are still working and don’t need the funds in the investment account, you can leave the money alone, continue to contribute to the account and let it continue to grow tax free as long as you live.
Putting money into a retirement account is for, well your retirement. Withdrawing money from your retirement savings before you retire is normally not a good idea, but sometimes having to do so is unavoidable.
- If you withdraw from a traditional IRA, the IRS charges a 10% early-withdrawal penalty if you are under the age of 59½ and taxes the money you take out as income at your current tax rate.
- A Roth IRA allows you to withdraw contributions at any time without having to pay income taxes or an early withdrawal penalty.
Be aware that there are various rules on early withdrawal of earnings from both traditional and Roth IRAs. Be sure to investigate those rules before you take money from your savings.
What should you do?
The ideal choice between a Roth IRA and a regular IRA can be confusing, especially when the decision may also involve a 401k plan or other retirement plan offered through an employer. Choosing the right retirement savings plan is a decision that, when made now in your pre-retirement years, will impact you in your later years. You’ll have to look at your situation and make assumptions about what might work best for you in the future.
As you can see, there are a lot of rules regarding eligibility, contribution limits, early withdrawal and minimum distributions. This is one area that you should get a financial professional to help you out.
A reputable financial advisor knows the different types of IRAs inside and out, and can guide you to the best choice for you. They can advise you based on your age, current tax bracket, income, retirement goals, lifestyle requirements, plus anything else that may affect your income and tax picture, such as a possible inheritance or other financial situations.
It’s well worth it to invest in the custom assistance of a qualified financial advisor, and possibly pay far less in taxes down the road by having made the right choice for your situation. Having an expert on your side can reveal tax considerations you haven’t taken into account for your own retirement and tax burdens, as well as those of your family members.
So which retirement plan is better for you? Well as you can see, it depends. There are a lot of factors that go into your particular use and benefits of a Roth IRA or a traditional IRA. The main difference is when and if the money is taxed.
For more details, listen to our podcast below, and contact us if you’d like us to help you decide which course to take.