Traditional IRA versus Roth IRA
Choosing the individual retirement account that best meets your needs is an important decision that can have a “big” impact on your future net worth and retirement lifestyle. Although several types of IRAs exist, the two most common types are the traditional IRA and the Roth IRA. Both types provide a tax break, but the timing of the tax advantage differs.
In the case of a traditional IRA, you receive a tax break when you put the money in, while the Roth IRA provides a tax break when you withdraw the money. For example, let’s say you earned $50k during the year and you decided to put $4k in an individual retirement account. If you opted for a traditional IRA, you would pay income tax on only $46k of the $50K you earned that year while your $4k deposit and earnings would grow “tax deferred” until you start to withdraw the funds many years in the future. When you decide to withdraw money from your traditional IRA account (you must be at least age 59 ½ or you will incur a 10% penalty) you will have to pay taxes on what you withdraw at your ordinary income tax rate. If you opted to contribute to a Roth IRA, you would pay income tax on the on the full $50k in the year you earned it even though you deposited the $4k in a Roth IRA but you will not ever pay any income tax again on all the earnings when you withdraw funds from your Roth IRA (you must be 59 ½ and the account must be at least 5 years old).
So both traditional IRAs and Roth IRAs provide a great tax shelter since they allow your money to grow taxfree. The Roth IRA earnings are basically tax-exempt (although contributions are not tax deductible), while the traditional IRA is tax-deferred since you will eventually have to pay income tax once you start withdrawing the funds in this account. One of the key factors that you should consider when choosing between a traditional or Roth IRA is what you think your future income tax bracket will be. If you expect to be in a higher tax bracket when you will withdraw funds in retirement compared to when you are contributing to the IRA then you should consider contributing to a Roth IRA as you would avoid paying income tax on future withdrawals at a higher tax rate. Conversely if you expect to be in a lower tax bracket when you retire you should consider contributing to a traditional IRA. Remember that although your future gross income might decrease, it doesn’t necessarily mean that your taxable income will also decrease because you might lose some income tax deductions in the future.
Another difference between a traditional IRA and a Roth IRA is that required minimum distributions (RMDs) are mandatory for the former starting no later than the year after you turn at age 70 ½ . If you do not complete the RMD in time you will end up paying a 50% penalty on the amount you should have taken as a distribution. The IRS publishes tables that help you calculate your RMD. The older you are the higher the RMD percentage becomes. The Roth IRA does not require you to take any RMDs which makes it an excellent wealth-transfer instrument.
Although both traditional and Roth IRAs allow fund withdrawals once the owner is 59 ½, the Roth IRA also requires the account to be at least 5 years old. However, a Roth IRA allows the owner to withdraw contributions, not earnings, even before age 59 ½ whereas the traditional IRA does not without penalty. Money can be withdrawn even before age 59 ½ but there will be associated penalties and taxes. For example, if you are a contributor to a traditional IRA and decide to withdraw funds before age 59 ½, you will have to pay a 10% penalty and the ordinary income tax according to your tax bracket. First-time home buyers can also benefit from a penalty-free $10k early withdrawal. There are also other exceptions to early withdrawal penalties, such as expenses related to higher education for the IRA contributor and/or family member. It is important to closely review the IRS rules before taking an IRA distribution.
There are contribution limits for both traditional IRAs and Roth IRAs which vary according to your age and over time the limits have increased due to inflation. In addition to a yearly contribution limit, there is also an income limit on making contributions so make sure you do not contribute if you are above the IRS limit.
If you have a traditional IRA and would like to convert it to a Roth IRA this is also possible although you will have to pay taxes on the the amount you convert that year so make sure the conversion doesn’t push you into a higher income tax bracket.