There are many options when it comes to how to save for retirement, with one of the most popular being an Individual Retirement Account (or an IRA). With two different types leading the pack, it can be hard to determine which type of IRA you should go for. Here, we break down the differences between a traditional and a Roth IRA, as well as their advantages and disadvantages so you can determine which type is right for you.
What is a Traditional IRA?
”A traditional IRA (individual retirement account) allows individuals to direct pre-tax income toward investments that can grow tax-deferred. The IRS assesses no capital gains or dividend income taxes until the beneficiary makes a withdrawal. Individual taxpayers can contribute 100 % of any earned compensation up to a specified maximum dollar amount. Income thresholds may also apply. Contributions to a traditional IRA may be tax-deductible depending on the taxpayer's income, tax-filing status and other factors.” - Investopedia
Tax deductions are made with pre-tax dollars
Flexible contribution restrictions
Extended contribution timeline per year (15.5 months instead of 12)
Required minimum distributions
Employer plans can interfere with tax-deductible contributions
Restrictions on investments
There are penalties for early withdrawal
What is a Roth IRA?
”Roth IRAs are funded with after-tax dollars; the contributions are not tax deductible—although you may be able to take a Saver's Tax Credit of 10% to 50% of the contribution, depending on your income and life situation. But once you start withdrawing funds, qualified distributions (see below) are tax-free.” - Investopedia
Savings grow tax-free
There are no required minimum distributions
There is no penalty for withdrawing contributions
With right distribution management, you can diversify your taxes in retirement
Taxes are paid upfront, rather than when you withdraw
The maximum contribution is low - only $6,000/year
You have to keep track of your account and set it up yourself
You can only open a Roth IRA if you meet the income limit requirements
Is one better than the other?
Not necessarily - the biggest difference between the two is how the contributions are taxed, so, depending on your situation, this will be the biggest factor in your decision. Your income will also help - if you make too much to contribute to a Roth IRA, then the decision’s been made for you.
Typically, people will opt for a Roth IRA if they can, mainly because of the lack of restrictions for withdrawals and during retirement. Also, while you may be getting an immediate benefit of tax breaks now when you contribute to a traditional IRA, you’ll have to deal with that when you retire. In the end, it’s up to you to decide which IRA is best for your situation.
Which type of IRA do you contribute to? Do you think one is better than the other? Let us know in the comments!