When planning for retirement in the USA, two popular types of individual retirement accounts (IRAs) are the Roth IRA and the Traditional IRA. Understanding their differences can help you choose the right one for your financial goals.
What is a Traditional IRA?
A Traditional IRA is a retirement savings account where you can contribute pre-tax money. This means you may be able to deduct your contributions from your taxable income in the year you make them. The money in the account grows tax-deferred, meaning you don’t pay taxes on it until you withdraw it in retirement.
What is a Roth IRA?
A Roth IRA, on the other hand, is funded with after-tax dollars. You pay taxes on your income before contributing to the Roth IRA. However, the money grows tax-free, and you won’t pay taxes on your withdrawals in retirement, as long as certain conditions are met.
Key Differences
1. Tax Benefits
- Traditional IRA: Contributions may be tax-deductible, lowering your taxable income for the year. However, you’ll pay taxes on withdrawals in retirement.
- Roth IRA: Contributions are made with after-tax money, so you don’t get an immediate tax break. The benefit comes during retirement when withdrawals are tax-free.
2. Withdrawal Rules
- Traditional IRA: You must start taking required minimum distributions (RMDs) when you reach age 73. Withdrawals before age 59½ may be subject to penalties.
- Roth IRA: There are no required minimum distributions during your lifetime. You can withdraw your contributions at any time without penalties, but you must be 59½ or older to withdraw earnings tax-free.
3. Contribution Limits
Both accounts have the same annual contribution limits. For 2022, you can contribute up to $6,000 per year, or $7,000 if you’re 50 or older. These limits apply to combined contributions if you have both types of IRAs.
4. Income Limits
- Traditional IRA: There are no income limits for contributing, but tax deductions may be limited if you or your spouse has a retirement plan at work and your income exceeds certain levels.
- Roth IRA: Contributions are limited by your income. If you earn too much, you may not be able to contribute directly to a Roth IRA.
The Right IRA
- If you expect to be in a higher tax bracket during retirement, a Roth IRA might be more beneficial because you’ll pay taxes at today’s lower rate and avoid taxes on withdrawals later, including possible gains from account growth.
- If you need a tax break now and expect to be in a lower tax bracket in retirement or you have a high income, a Traditional IRA might be the better choice.
The worst scenario is not having either of these two options in your retirement plan. Both Roth and Traditional IRAs offer valuable benefits, so it’s important to consider your current financial situation and future expectations when deciding which account is right for you.