If you are self-employed or your employer does not offer a 401K or other retirement plan, investing in an IRA is a great way to start saving for retirement. An IRA is typically purchased through a financial institution, such as Fidelity, that will then manage the underlying mutual funds for a fee. If you are looking to fund your retirement independently through the use of an IRA, then you may wonder about the differences between a traditional IRA and a Roth IRA. Keep reading to learn how your choice will affect contribution limits, taxation, and withdrawals as well as other key differences between these two financial vehicles.
One of the main differences between these two options is the different tax treatment that they each receive. Roth IRA contributions are made with post-tax dollars while traditional IRAs use pre-tax monies. This means that with the Roth you pay your taxes in the year the money is earned, and then make the contribution to your account. With a traditional IRA, you pay taxes when the money is withdrawn, at your tax rate at the time of withdrawal. This makes the Roth ideal for younger investors who will likely have a higher tax bracket as they move forward on their career paths.
There are also differing age requirements between the two. You can contribute to a Roth IRA at any age, while the age cutoff for contributions to a traditional account is 70.5.
Contribution limitations that are triggered by income effect only the Roth IRA. Income limitations start after $117,000 of annual income is earned for Roths, while there are no income limitations for contributions to traditional IRAs.
Taxation at the time of withdrawal is another significant difference between the two types of IRAs. There are no taxes due on Roth withdrawals as taxes were paid prior to contribution. For a traditional IRA, taxes will need to be paid at the time of withdrawal for contributions and earnings.
Early withdrawal penalties vary depending on the unique circumstances of every situation, but the general rule is to expect a 10% penalty on any premature withdrawal for both Roth and traditional accounts.
Required Minimum Distributions (RMDs) begin once you turn 70.5 for traditional IRAs while there are no RMDs for Roth accounts. These forced distributions can affect both your tax bill as well as your retirement nest egg, so be sure to plan accordingly.
Saving money for retirement is a very important part of your overall financial strategy and should be started as soon as possible, no matter the amount of your initial contributions. Discuss the implications of choosing a Roth over a traditional IRA with your financial advisor prior to making any decisions, as the implications can have a significant effect on your future tax burden. IRAs offer an effective vehicle for individuals to start their retirement savings on their own, while enjoying tax benefits either now or at the time of retirement. Creating a nest egg for your later years will help to increase your peace of mind and also allow you to enjoy your retirement years in comfort.