Traditional individual retirement accounts (IRAs) and Roth IRAs are tax-advantaged retirement accounts. An individual retirement account (IRA) is one of the best tools for retirement savings. However, you may notice when enrolling that IRAs come in two different types: traditional IRAs and Roth IRAs. Both offer significant tax benefits, but the key differences could make one a better choice for you, depending on your financial goals and situation.
What is the difference between traditional IRAs and Roth IRAs?
Traditional IRA:
- Contributions are tax-deductible, allowing you to deduct contributions from this year’s taxes.
- The annual contribution limit is $6,500 with no income limits; an additional $1,000 contribution is allowed annually for individuals over age 50.
- Qualified withdrawals are taxable and begin at age 59½.
- There is no minimum required distribution rule.
- Available widely from brokerage firms and other financial companies in the form of investments, savings accounts, and certificates of deposit.
Roth IRA:
- Contributions are made with after-tax dollars, and contributions cannot be deducted from this year’s taxes.
- The annual contribution limit is up to $6,500 (or $7,500 if you are age 50 or older), but income limits apply.
- Qualified withdrawals are tax-free and begin at age 59½.
- There is no minimum required distribution rule.
- Available widely from brokerage firms and other financial companies in the form of investments, savings accounts, and certificates of deposit.
These annual contribution limits will take effect on January 1, 2023. They are increased by $500 from 2022.
Qualified Distributions
Qualified distributions from both types of IRAs are available when you reach age 59½. You should remember that traditional IRA withdrawals are taxable, while Roth IRA withdrawals are tax-free. You can withdraw contributions from your Roth IRA at any time without penalties because these funds have already been taxed. However, there are more complex rules regarding when you can withdraw account earnings. You can withdraw earnings from your Roth IRA only after age 59½. Withdrawing them earlier could result in taxes and a 10% penalty.
Required Minimum Distributions
You must take required minimum distributions (RMDs) when you reach age 72 if you have a traditional IRA. The amount you must withdraw uses a complex formula based on your age and account balance. Check with the IRS or your investment broker to ensure you don’t make mistakes here, as it could lead to additional taxes or penalties.
A Roth IRA does not require the account holder to take any required minimum distributions. You can leave your contributions and earnings in the Roth IRA until you pass away.
Account Investments and Availability
Both types of IRAs allow for a range of supported market investments, including exchange-traded funds (ETFs), mutual funds, stocks, and bonds. You can open either type of IRA at a broker or bank.
Which one is right for me?
Generally, younger investors benefit more from a Roth IRA early in their careers because their investments will grow tax-free for decades. Younger investors may also have lower annual income from work, thus falling within income requirements for maximum contributions. These investors can withdraw significant earnings without paying taxes on the gains in retirement.
The upfront tax benefits of a traditional IRA may hold more value for investors nearing retirement since they have fewer years for their investments to grow before they stop working. High-income individuals earning more than enough to qualify for a Roth IRA can contribute to a traditional IRA.
It might…
Older investors find the tax deduction benefits of traditional IRAs appealing. Remember, you can also make additional contributions of up to $7,500 after age 50 starting in 2023 with no income restrictions.
A Choice That Combines the Best of Both Worlds
There is no law stating that you cannot own both a traditional IRA and a Roth IRA, although contributing to both in the same calendar year can be complex. Some savers receive similar benefits to those available in a traditional IRA when investing in an employer-sponsored retirement plan like a 401(k) or similar retirement account. They can also use a Roth IRA to take advantage of tax-free benefits.
Combining a 401(k) with an IRA and a Health Savings Account (HSA) can help you save on taxes through multiple investment accounts if you qualify. There is no one-size-fits-all solution, but you can work on your budget, savings ability, and future needs to find the saving strategy and investment account that makes the most sense for your retirement future.
Conclusion
Investing is crucial for most Americans seeking to maintain the same standard of living during retirement as they enjoyed during their working years. Many investment experts suggest saving at least 15% of your pre-tax income for retirement, including through individual retirement accounts, 401(k) plans, and other tax-advantaged accounts.
An IRA might be the perfect solution for you if you have not yet started saving for retirement or do not have access to an employer-sponsored retirement account.
Frequently Asked Questions
Which is better, Roth IRA or traditional IRA?
Generally, it may make sense to use a Roth IRA if you believe your retirement tax rate will be higher than your current rate. Your qualified withdrawals will be tax-free. A Roth IRA offers tax-free withdrawals as long as you meet the exception requirements if you need to access cash before retirement for other purposes, such as buying a home. However, a traditional IRA may make more sense if you think your tax rate will be lower in retirement than it is now, or if you earn too much to qualify for a Roth IRA.
What are the tax implications when withdrawing from a Roth IRA vs. a traditional IRA?
You can withdraw your Roth IRA contributions and earnings tax-free by distribution once you reach age 59 and a half since you’ve already paid taxes on that money. When withdrawing contributions or earnings from a traditional IRA, they are taxable. This is true whether you withdraw before age 59 and a half or later. Both types of withdrawals may incur an additional 10% penalty if the withdrawals do not meet the exception requirements.
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References:
- IRS. “Retirement Topics – IRA Contribution Limits.”
- IRS. “Traditional and Roth IRAs.”
- IRS. “Amount of Roth IRA Contributions That You Can Make for 2022.”
- IRS. “Amount of Roth IRA Contributions That You Can Make for 2023.”
- IRS. “Publication 590-B (2021), Distributions From Individual Retirement Arrangements
Source: https://www.thebalancemoney.com/should-i-use-a-traditional-or-roth-ira-1289864
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