One of the most common questions I get from people who are ready to get serious about investing is the best tool to use.
Of course, many of us get our start investing in a workplace retirement plan, such as a 401(k) or 403(b). But there are also options to help you invest for retirement outside of your employer. Those options include a traditional IRA and Roth IRA.
Both traditional and Roth IRAs come with some advantages and disadvantages, especially as it relates to your taxes. As a result, each may be best suited to a certain type of investor.
In this article, I’ll explain the differences between the two types of retirement accounts and how to choose the right one for you.
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 $144,000 or lower (single filers) or $214,000 (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
*For the traditional IRA, whether you can deduct your contributions depends on your annual income and whether you have a retirement plan through your employer. If you don’t have a workplace retirement plan, you can deduct your contributions no matter what your income. If you have a workplace retirement plan, you can no longer deduct your contributions once your income reaches $78,000 for a single filer and $129,000 for a married filer.
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.
Ultimately, it depends on your financial situation today compared to what you expect your financial situation to be in the future.
Traditional and Roth IRAs give you a tax advantage at different times. A traditional IRA gives you a tax break in the year you make the contribution. Because you can deduct your contributions, your taxable income – and, therefore, the amount you owe in taxes – is lower.
As a result, a traditional IRA may be the right option for someone with a high income today who expects to have a lower income during retirement. You take the tax benefit now while your tax rate is high rather than later when your tax rate will be lower.
On the other hand, a Roth IRA tends to be a great option for people early in their careers who expect their incomes to grow. You can pay the full tax amount in the current year when your tax rate is relatively low. Then, you won’t have to pay taxes when you withdraw the money when your tax rate may be higher.
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.
INCOME LIMITS ON IRAS
As a caveat to the information about, there are certain income limits applied to IRAs.
We’ve already addressed the income limit on deducting your contributions to a traditional IRA. However, there is also an income limit on contributions to a Roth IRA. If your income is higher than the limit, you can’t contribute directly to a Roth IRA.
These income limits may impact which IRA you choose. After all, there’s no use contributing to a retirement account if you won’t get the tax benefits. If income limits prevent you from taking advantage of these accounts or fully enjoying the benefits, it may be worth choosing a different option or contributing more to your workplace retirement plan.
As a final note, self-employed individuals have more options aside from the traditional and Roth IRA. Learn more about how to save for retirement when you’re self-employed.
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.