Saving for Retirement: Key Differences Between a Traditional or Roth IRA
Having a healthy nest egg is essential to keep you in control of your finances in an insecure future. An Individual Retirement Account, or IRA, has become an invaluable tool for saving for those lean retirement years because they provide tax incentives that you’ll never get from a savings account or from stuffing cash under the mattress. But there’s some strategy involved in deciding whether a traditional or Roth IRA is right for you.
You’ve probably heard the doom and gloom stories of how social security might not survive for the long term. Whether these projections are true or not remains to be seen, but you only have to look at current benefits to see why investing in an IRA is a smart idea.
Currently, you can expect about $1,360 per month on average from social security, hardly enough to stay afloat. Also, you must consider that social security benefits haven’t historically kept up with inflation. Goods and services become more expensive, but your benefits don’t increase at the same rate.
This isn’t meant to depress you about the future, but rather to signal that it’s time to plan on having an alternative source of income to supplement your benefits. This is where an IRA comes in. With some smart moves, you can set yourself up with a comfortable financial future without relying on uncertain government programs.
What is an IRA?
Individual Retirement Accounts allow you to stash away a portion of your earnings in a tax-free account that earns interest over time. There are two different types of IRA account: Traditional and Roth. Each type provides its own unique tax breaks and serves two different types of investors. First, we’ll start with the similarities between Traditional and Roth IRAs.
Both types of IRA accounts have limits on how much you can contribute in a given year. In 2016, this limit was $5,500 for both Traditional and Roth IRAs if you are under the age of 50. If you’re over 50, your limit rises to $6,500 per year.
For Traditional and Roth IRA accounts, there is a penalty for withdrawing money before you turn 59 ½. The upside is that you’ll have money to throw an amazing 60th birthday party. Plus, there are some exceptions. Both types allow you to withdraw up to $10,000 without penalty if the money is used for first-time homeowner expenses and some educational costs. This makes IRAs an attractive option for young families planning to buy a house or for college students who think they may want to invest in a home in the future.
Give yourself some tax credit
Both accounts offer substantial tax benefits. But, these tax advantages differ depending on whether you invest in a Traditional or Roth account. In this section, we’ll explain these differences, then explore which might be the best option for your situation.
During your working years, a Traditional IRA will benefit you most around tax time. You can deduct contributions for Traditional IRAs on your tax return, which will result in a lower tax bill. Additionally, these deductions will also lower your annual gross income, which could qualify you for additional tax credits, such as the childcare tax credit, the Earned Income Tax Credit (EITC) and student loan interest deductions.
Conversely, contributions to a Roth IRA are not tax deductible, which might at first sound unappealing. But like a bad infomercial, just wait because there’s more! The downside to a Traditional IRA is that you do have to pay tax on your withdrawals. But as long as you abide by a few rules, then your Roth withdrawals will not be taxed. One rule is that you must wait five years after making your first contribution before you can make a withdrawal. Otherwise, you’ll be liable for a 10% tax penalty. So, the IRA debate basically comes down to whether you want to be taxed now or later.
The rules of withdrawal
Traditional and Roth IRAs also have different rules about how and when you can access your money. We’ve already talked about the 59 ½ age limit for withdrawals, but a Traditional IRA also forces you to begin making withdrawals when you turn 70 ½.
The 70 ½ birthday rule does not apply to a Roth IRA. In fact, you never have to withdraw money from a Roth IRA if you don’t need to. This makes a Roth account a great inheritance vehicle because you could conceivably hold your money in the account, then gift it to your children or another beneficiary. Better yet, the heir won’t be taxed when they make withdrawals, although they will still be liable for paying estate taxes. Also, if you inherit a Roth IRA, you must withdraw a required minimum amount each year, so it’s not possible to sit on the account for more than one generation.
There’s one more key difference between IRA accounts concerning how much you’re able to earn in a year. For Roth IRAs, you must have an income less than $117,000 per year for single filers. For joint filers, your combined earnings cannot exceed $184,000. There are no income limits for a Traditional IRA account.
Which one is good for me?
The type of IRA account you choose largely has to do with how much you expect to earn in the future. If you expect to be a lower tax bracket upon retirement, then a Traditional account will work best because you can take advantage of tax credits during your working years, then pay a lower tax bill when you’re chilling in your retirement years.
We tend to assume that we’ll be making less money when we retire, but this isn’t always true. Keep in mind that you’ll likely have less expenses by that time, especially if you have children because they will no longer be living with you (at least in theory). So, it’s not always true that you’ll be a lower tax bracket when you retire, even though this is typically the case.
Timing is another issue, depending on how long you have to go before you retire. If you’re worried about keeping your money stored away for twenty or thirty years, then a Roth IRA will give you more flexibility in accessing your money. While you won’t be able to touch any earnings before 59 ½, you can withdraw contributions without penalty. Just remember that you must wait five years to withdraw your money after making your first contribution.
And finally, there’s those income limits to think about. If your income is above $117,000, then you’ll have no choice but to go Traditional because you don’t qualify for a Roth. At least that makes your choice clear and easy.
Roth and Traditional: Both good options
Regardless of which type of IRA account you choose, know that you’re making a smart choice either way. Most of us don’t think about our retirements until it’s too late. By getting in the game early and making contributions when you’re young, your retired future self will thank you for thinking of them.
When you’re young, you can always take that extra shift or work that second job. But this is less of a reality as you get older. An IRA account can help ensure that you have a nice stockpile put away so instead of worrying about the future, you can embrace retirement.
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