Know the difference between Traditional and Roth IRAs.
Financial planning for the distant future is important no matter what age you are. If you’re in your 30s or 40s, thinking about retirement might be something that rarely crosses your mind. You’re young, so why should you think about old age? Taking into consideration that 50 percent of households are at risk of not having enough money to keep their lifestyle when they reach retirement, taking the matter into your own hands early on by opening an IRA is an intelligent move that you’ll be thanking yourself for when you retire.
Before you open an IRA account you will need to choose between the two types: a traditional IRA or a Roth IRA. In this article, you will learn what Traditional and Roth IRAs are and how to choose the best one for your retirement.
What Are Traditional and Roth IRAs
IRA stands for Individual Retirement Arrangement but often interchanged with the word account. It’s an IRS specific arrangement offering multiple accounts to invest a part of your income so you can use it when you retire. The reason why you should open an IRA is that you will have some pretty sweet tax advantages, the kind that you won’t get with the regular savings account.
The traditional IRA is the individual retirement account that keeps your investments free from taxes on capital gains. You will have to pay income taxes when you withdraw money from the traditional IRA once you retire.
If you choose a Roth IRA your contributions will not be tax-deductible, but it will allow you to invest your money after taxes, up to a certain amount each year. The earnings and withdrawals from the Roth IRA are tax-free after age 59½.
You should know that an IRA has a contribution limit. The contribution limit for 2021 is $6,000 if you’re younger than 50. If you’re 50 or older than that the limit is $7,000.
How to Choose Your IRA: Pros and Cons
The best way to know how to choose your IRA is to see the differences between a traditional IRA and a Roth IRA, which we’ll detail below.
Tax bracket. You should think about how your tax rate will be in the future: will it be higher or lower? A Roth IRA will be better for you if the tax bracket in retirement is higher because you get the delayed tax benefits. A traditional IRA is best for people with a lower tax rate in retirement because of the capital gains taxes being deferred.
Eligibility. Besides the contribution limit we talked about, you should also know that the Roth IRA comes with an income limit, meaning that depending on your income you might be eligible for a Roth IRA or not. The income limit of a Roth IRA for 2021 is $140,000 if you’re a single filer and $208,000 for joint filers (together with your spouse).
Now let’s take a look at the key benefits and the cons when choosing a Roth IRA and a traditional IRA, so you can see the differences that can make your retirement life smoother from a financial perspective.
Roth IRA benefits (pros)
- Because your contributions in a Roth IRA are made with the money left after you paid taxes, the potential earnings will see growth without taxes.
- You can withdraw your money from a Roth IRA without taxes and penalties any time, without stating a reason. You can do this only if you made your first contribution at least 5 years ago or if your age is 59½. We recommend that you refrain from going into your retirement savings account unless it’s an emergency that you don’t have a backup plan for.
- It’s not mandatory to withdraw a minimum amount from a Roth IRA no matter what age you are.
- You can keep your money in your Roth IRA for as long as you wish in order to grow without being taxed.
- You get more savings after tax in retirement.
Roth IRA cons
- You can’t apply for a Roth IRA if your income is higher than the limit accepted, as detailed previously.
- You don’t get immediate tax benefits when making contributions.
- If you want to withdraw your earnings (not savings) early you might have to pay a penalty of 10% or income taxes, unless there’s an exception.
Traditional IRA benefits
- You can use your money without any penalty after age 59½.
- Your potential earnings will grow tax-deferred.
- You’re not taxed until you reach retirement and you withdraw the money.
- There is no income limit.
- Your contributions can reduce the taxable income in the year they were made. That is if they are deductible.
Traditional IRA cons
- If you take money out of a traditional IRA before the retirement age you will have to pay income taxes on gains and taxable contributions.
- Early withdrawal will also cost you a 10% penalty.
- After age 72 you will need to withdraw a minimum amount of money.
If you want to have a financial cozy retirement, it’s time to think about opening an individual retirement account. And if you want to learn more about your retirement financial options we are here to help you reach your goals.