One of the most common questions I get from people who are ready to get serious about investing is whether they should use a traditional IRA vs. Roth IRA.
Both of these accounts allow people to invest for retirement outside of their employer-sponsored plan. And both come with their own tax benefits.
In this article, I’ll explain the differences between the two types of retirement accounts and how to choose the right one for you.
Traditional IRA vs. Roth IRA: Which is Better?
What is an IRA?
An IRA (which stands for individual retirement account) is a tax-advantaged investment account to help you save for retirement. Unlike 401(k) plans, which are offered through an employer, IRAs are for individuals to invest on their own.
You can open an IRA at just about any brokerage firm. Once you open the account and start contributing money, you can decide how you want to invest the money within the account.
Why open an IRA
If you already have a 401(k) through your employer, you might be wondering why an IRA is necessary at all. There are a few reasons why I recommend everyone open an IRA, even if you have an employer-sponsored retirement plan:
- An IRA allows you to invest above and beyond the 401(k) contribution limits
- An IRA allows you to diversify your tax advantages — If you have a traditional 401(k), you can open a Roth IRA, and vice versa
- An IRA gives you more control over your investment decisions
What is a Traditional IRA?
A traditional IRA is similar to a 401(k). You can contribute to the account throughout the year, and then take a tax deduction for your contributions. Contributing to a traditional IRA reduces the amount of taxes you owe in that year.
The money grows in the account. Once it comes time to take money out during retirement, you’ll pay income taxes on your withdrawals.
What is a Roth IRA?
A Roth IRA is also a tax-advantaged retirement account, but you get the tax advantage at a different time.
When you contribute to a Roth IRA, you do so with after-tax money. There’s no tax break in the year you contribute the money. The money grows in your IRA, and then you can withdraw it tax-free during retirement.
Similarities and differences
Traditional IRAs and Roth IRAs have a lot in common, but there are also some key differences you need to know. Here’s a table to explain all of the similarities and differences:
Available to anyone
Available to individuals with income $139,000 or lower (single filers) or $206,000 (joint filers)
Early withdrawals on contributions and earnings taxed at 10%
Early withdrawals on earnings taxed at 10%; No penalties for early withdrawals of contributions
No required withdrawals
Required minimum distributions starting at age 72
People who expect to be in a lower tax bracket when they retire
People who expect to be in a higher tax bracket when they retire
Should I choose a Traditional IRA or Roth IRA?
Plenty of people find themselves overwhelmed when choosing between the traditional IRA and the Roth IRA. It ultimately comes down to your personal financial and tax situation.
A Roth IRA is the best option for most people for a few different reasons:
- If you have a traditional 401(k), you can diversify your tax benefit
- You can withdraw your contributions without early withdrawal fees
- Most people will end up with more retirement savings with a Roth IRA
There are some caveats to this advice though. First, many of us will be in a lower tax bracket when we retire. As a result, the traditional IRA would really make the most financial sense.
But here’s the thing…
Many people aren’t going to use the tax deduction to contribute more money to retirement. Instead, they’re likely to spend their tax return. The tax savings isn’t going toward retirement.
But with a Roth IRA, you get the tax advantage when you withdraw the money during retirement, which means that’s when you get the benefit.
The other thing to keep in mind is that not everyone can contribute to a Roth IRA. Because of the income limits, only individuals earning less than $139,000 and couples making less than $206,000 can contribute to this type of account.
To learn more about the features of the different types of IRAs, visit the IRS guide.
If you’re still struggling to choose the right IRA, you can use a Roth vs. traditional IRA calculator where you enter some basic financial information and it recommends the right retirement savings tool for you.
Choosing the right type of retirement account can be overwhelming. Hopefully, this explanation of the differences between the traditional IRA and Roth IRA will help you find the right account for you.
And remember — both of these accounts help you to save for retirement in a tax-advantaged way. As long as you’re setting money aside for the future, you’re on the right track.