What Is the Difference Between a Roth and a Traditional IRA?
Since its inception in 1974, the individual retirement account, also known as an IRA, has become a popular retirement savings tool. According to a study from the Employee Benefit Research Institute, there are more than 25 million IRAs open in the United States, and those accounts hold nearly $2.5 trillion in total assets.1
There are many reasons why the IRA is commonly used to save for retirement. Perhaps one of the biggest reasons is the account’s tax benefits. Depending on which type of IRA you own, you may benefit from tax deductions for your contributions, tax-deferred growth or even tax-free withdrawals in retirement.
There are several types of IRAs, so you may not be sure which type is right for you. The traditional IRA and the Roth IRA are the two most commonly used types. Unless you are self-employed or have some other unique situation, the traditional IRA and the Roth IRA are the two account types most likely to be available to you.
Not sure whether you should use a Roth or a traditional IRA to save for your retirement? The answer depends on your unique goals and needs. Below are descriptions of each type, along with suggestions on how you can decide which type of IRA is best for you:
Traditional IRA: Tax Benefits Now
A traditional IRA could be the right choice if you are looking for tax relief today. When you make contributions to a traditional IRA, you may be able to deduct those contributions from your current-year tax return. There are income limits on these deductions, so you may not be eligible if you’re a high-earner.
Your contributions then grow tax-deferred as long as they stay in the account. That tax-deferred growth could help your funds compound at a faster rate. However, your distributions from the traditional IRA in retirement are taxable.
As is the case with most qualified savings plans, you must wait until you’re age 59½ to start taking withdrawals from your traditional IRA. If you take withdrawals before age 59½, you could face a 10 percent early distribution penalty. Additionally, you are required to start taking distributions from a traditional IRA no later than age 70½. Failure to take distributions at that age could trigger additional taxes and penalties.
Roth IRA: Tax Benefits Later
The Roth IRA is a more recent variation of the traditional IRA that offers slightly different tax advantages. It could be the right choice for you if you are more concerned with future taxes than with taxes today.
The Roth IRA does not offer deductions for your contributions. Contributions are made with after-tax dollars. However, like a traditional IRA, your contributions still grow tax-deferred as long as they stay in the account.
The biggest benefit of a Roth comes after you retire. After you reach age 59 ½, can take tax-free withdrawals from your Roth IRA. That means you can save money today and invest it over time to create a tax-free income stream in retirement.
The Roth IRA also offers slightly more flexibility with distributions before age 59½. You can withdraw your contributions early without facing taxes or early withdrawal penalties. Also, the Roth does not require you to take distributions starting at age 70½, which could be helpful if your goal is to accumulate assets for later in life.
How to Use Both Types of Accounts
What if you see advantages in both types of IRAs? How do you choose between the two?
You may not have to choose between one or the other. You could opt to contribute to both a traditional IRA and a Roth. As long as the total contributions don’t exceed the annual IRA contribution limit, you can put money into both types of accounts.
You could also choose to convert a traditional IRA to a Roth sometime in the future. A Roth conversion is a process in which you pay taxes on your traditional IRA funds, and then transition those funds into a Roth IRA to generate tax-free income in retirement.
Ready to develop your IRA savings strategy? Let’s talk about it! Contact us today to set up a free initial strategy session, where we can help you analyze your needs and develop an appropriate retirement savings strategy for your needs.
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