If you’re thinking about your retirement accounts (and nowadays who isn’t), you may be wondering about the difference between a Roth IRA and a traditional IRA. Is one type of account better than the other? How do each of them effect your taxes and the amount of money you actually get to use when you retire?
Here are some basics to help you decide how to best put each type of IRA to work for your retirement portfolio.
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 basically means is you don’t need to pay income tax on the money that you deposit 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, assuming 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 based on filing status, income, and whether or not you are covered by a retirement plan at work. Basically, if you are covered by a work plan, then high income and marital status may limit your deductions.
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, based on your income at that time (which most likely will be lower than now).
Since an IRA is meant for retirement savings, there are penalties for withdrawing money early from your account. Any money that is withdrawn before age 59 ½ will require you to pay back taxes on that money, as well as an additional 10% penalty on that amount.
There are some exceptions to the penalty. 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 still have to pay 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. The exact amount will depend on a number of factors, including your account balance. 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, any money that you earn in your account is not subject to capital gains taxes.
In addition, there are no required distributions for a Roth IRA 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:
• Both offer tax advantages compared to a regular savings account
• Both allow for investment in many different investment products
• Both are easy to open
• Current annual contribution up to $5,500 ($6,500 age 50 or older)
Summary of differences:
• Traditional – pre-tax dollars; Roth – after-tax dollars
• Traditional – Required Minimum Distributions (RMD); Roth – No RMD
• Traditional – Early withdrawal penalty and back taxes on any early withdrawal; Roth – No penalty or taxes on early withdrawal of principal
• Traditional – Contributions often tax deductible; Roth – Contributions not tax deductible
Which IRA will get me more money when I retire?
That depends on your specific situation. If you aren’t earning a significant amount of money right now, you’re probably better off with the Roth IRA. You’ll pay a small amount of taxes right now, and not have to worry about the taxes when you retire, when you may or may not be earning more money. (Some folks still work, by choice or otherwise.)
On the other hand, if you currently have high earnings, you might be better off going for the traditional IRA (to the extent you qualify), as you won’t pay taxes now, and you likely will be in a lower tax bracket when you do retire, especially if you aren’t working.
For some folks, though, getting and feeling the deduction now (especially if it lowers your tax bracket) and also investing in a non-retirement account anyway provides a satisfying compromise. Just remember that the tax bite on your traditional IRA will come when you finally need to use that money!
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, the investments are equal for both types of IRAs. Stocks and stock mutual funds offer greater opportunity for significant long term gains, but at a greater risk. The general rule is that 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
Be wary, however, of medium and especially long term bond funds, as they have potential for significant losses and 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.
And remember to always check for fees and hidden costs. Ask whether the investments you choose have any fees / loads. Also, 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, it’s common for banks to 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 call 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 to manage what you do have wisely.
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