If you want to have a substantial nest egg for retirement, it's essential to start saving as early as possible. IRAs are one of the vehicles you can use to help save money while still in the workforce. There are two main types of IRAs (Individual Retirement Accounts): The Roth and Traditional IRA.
When choosing which type of account is right for your retirement savings needs, it is important to understand how each of them works, how they are different, and what your preferences are. Below is an overview of the Roth and traditional IRAs to help you make your choice.
What is a Traditional IRA?
Traditional IRAs provide upfront tax deductions to savers, which can be particularly attractive for those seeking to lower their present tax bill. It also means that you can grow your investment tax-deferred, similar to how a 401(k) works. A traditional IRA might also be the right choice if you expect your tax rate will be reduced upon retirement.
The contribution limits for traditional IRAs is $6,000, or $7,000 if you are over 50 years of age in 2019. You can continue to make contributions until you are 70 and a half years old. You may qualify for a tax deduction for the year you contribute. Even if you don't receive a tax deduction, you are still funding your account.
Since your investments are tax-deferred, you won't be taxed on the gains until you start making withdraws. If you make withdrawals earlier than the minimum age requirement of 59 and a half or don’t meet other conditions for early withdrawals, you will pay a 10% penalty. There is also a required minimum distribution that starts when you turn 70 and a half. All of the retirement distributions are considered ordinary income and are taxed as such.
What is a Roth IRA?
Roth IRAs are very similar to traditional IRAs, as they both offer a wide variety of investment options and have the same contribution limits. The difference that stands is that contributions to a Roth IRA are after-tax dollars. Because you have paid the taxes, distributions from a Roth IRA are free from penalties and taxes.
To avoid penalties or paying taxes on withdrawal transactions, your distributions must meet specific qualifications. The distribution cannot be taken earlier than five years from the time you first funded the account, with the fifth-year period beginning the tax year of the first contribution made. Additionally, one of the following requirements must also be met:
- You are 59 and a half years old
- Have a disability
- A beneficiary or beneficiaries receive your distribution when you pass away
- The distribution is used to purchase a first home (a lifetime limit of $10,000 could apply)
If you expect the tax rate during your retirement to be higher than your current tax rate, Roth IRAs are generally the better choice. This is because Roth IRAs pay taxes in the present.
Roth IRAs do not have a required minimum distribution like traditional IRAs . So, the choice of when you want to use your money is up to you.
Choosing Between a Roth or Traditional IRA
The time frame in which you get your tax break is the biggest differentiator between the two types of IRAs. Traditional IRAs allow you to take a tax break the year you make your contribution, whereas Roth IRAs withdrawals won't be taxed. Also, check into whether you can anticipate a higher or lower tax rate when you retire.
The IRS rules regarding your IRA eligibility could also determine which type of IRA you choose. If you are a high-income individual, your income level may limit you from being eligible to make contributions to a Roth IRA. Your income will also determine how much money you can contribute to a traditional IRA and deduct from your taxes. Also, if you or your spouse have access to a 401(k) or another type of workplace savings plan, you may also have restrictions on your IRA deductibility. Something else to be aware of, you may contribute to both types of accounts in the same year as long as the total amount is not more than the allowable contribution limit.
Ready to open an IRA? NASB can help you get started or answer any additional questions you might have at 800-677-6272.