IRA’s: Roth vs. Traditional?
Planning for retirement can be a daunting enough task without even more complexity being added with differences between different types of retirement accounts. That’s exactly what the US government has given us when passing into law two types of IRA retirement accounts.
Similarities
Before we go into the differences, let’s look at the similarities. Both types of IRA’s allow you to contribute to them and the investment gains grow tax deferred until you take distributions in retirement. Both have a 10% early withdrawal penalty if you take any distributions before age 59 ½. Also both types of IRA’s have maximum contribution limits per year based on your age. Both also allow you to invest in a variety of investments including ETF’s, mutual funds, bonds and stocks.
Differences
The traditional IRA account is similar to the 401(k) program. Contributions are pre-tax so your contributions grow tax deferred until you start taking distributions in retirement. Once you start taking distributions for retirement income, it will be taxed as ordinary income. Unlike the Roth IRA, the traditional IRA is able to be contributed to even if you have high income.
2013 Traditional IRA Contribution Limits Below:
- $5,500 per year
- $6,500 per year (age 50 and over)
The Roth IRA is different in that you contribute after-tax dollars to your retirement account. The investment gains are also able to grow tax deferred but once you start taking distributions, they’re tax free. That’s right; you don’t pay any tax on distributions in retirement! So you trade off the tax payment now to get tax free income later. This is the major difference between the Traditional and Roth IRA’s. Another significant difference is that if you make more than a certain amount of income, you’re not able to make contributions for that tax year.
2013 Roth IRA Contribution Limits Below:
- $5,500 per year
- $6,500 per year (age 50 and over)
- For singles, after your adjusted gross income reaches $112,000 your contributions start getting limited. If your AGI is more than $127,000 in a year you cannot contribute to a Roth IRA in that year.
- For married couples, after your AGI reaches $178,000 your contributions start getting limited. If your AGI is more than $188,000 in a year you cannot contribute to a Roth IRA in that year.
Although I’ve listed the 2013 contribution limits here, the figures are revised every few years so it’s important to check the IRS website every year to see if there are any revisions.
Making the Right Choice for Your Retirement
Many people often ask how do I know which one to choose? Well first of all, you have to make sure you have a choice. If you make too much income you’ll be forced use the traditional IRA. If you have a choice though, it becomes a strategic choice. If you think you’ll pay more taxes in the future then it makes sense to open and use the Roth IRA. This is because you will pay your lower tax rate now and not pay taxes again when you take distributions in the future. If you want to lower your taxes today or you make too much income to qualify for the Roth, then a traditional IRA might suit you better. Although you can choose between the two, you can also have one of each type by law.
The differences between the traditional and Roth IRA’s don’t need to be confusing to understand. After reading this blog post, I hope you have a better idea of what the differences are and also how each one can make sense for you depending on your long term retirement needs and future tax bracket projections.
Disclaimer: Please seek professional advice regarding tax liability and investing options based on your personal situation.