Roth IRA vs. Traditional IRA
Most Americans nowadays do not save enough for retirement. One of many options for saving for retirement is starting an IRA – Individual Retirement Account. An Individual Retirement Account can be viewed as an investing tool used by individuals to invest in a retirement savings account. There are several types of IRAs including: Traditional IRAs, Roth IRAs, SIMPLE IRAs and SEP IRAs. IRAs carry a wide range of financial products such as stocks, bonds, or mutual funds. Our focus today is to differentiate between Roth IRA and Traditional IRA, as most individuals wonder; what their best choice, as far as saving for retirement and getting the most tax benefit out of the two options available.
One of the major benefits of starting a Roth IRA, is that you get to grow your money tax-free. This is mainly due to the fact that you are contributing money after tax, and your principle will grow tax free until the age of retirement. Once you retire, you can start withdrawing from your Roth IRA account, and simply pay taxes only on your capital gain made and not the principle.
Another advantage of a Roth IRA, is that there is no age restriction as far as the contributions are concerned. However, there are income-eligibility restrictions. For example, in 2018, single tax filers must have Modified Adjusted Gross Incomes (MAGI) of less than $135,000 to contribute to a Roth IRA. There is also a phase-out amount of MAGI $120,000—per IRS guidelines. For married couples filing jointly, they must have a modified AGI of less than $199,000 in order to contribute to a Roth IRA; and consequently their contribution limits are phased out starting at $189,000.
The major and very famous benefit of a Traditional IRA, is that the contributions made are tax deductible. As long as you meet certain criteria, and income limitation, then you can deduct the contributions made throughout the year. Once you lower your adjusted gross income, this helps you to qualify for other tax incentives you wouldn’t otherwise get, such as the child tax credit or the student loan interest deduction. Keep in mind, that if you or your spouse have an employer retirement plan, your ability to deduct contributions may be reduced or eliminated.
You must be under age 70½ to contribute to a traditional IRA. The amount you can contribute to a traditional IRA cannot exceed the amount of income you earned that year; and there is also a phase-out amount imposed by the IRS. In 2018; if you are under the age of 50, you can contribute up to $5,500 per year. If you are over the age of 50, you are allowed to contribute up to $6,500 per year.
As mentioned earlier, the major tax incentive of a Roth IRA, is that you get to grow your money tax-free. And since Roth IRA contributions are made on an after-tax basis, it might be wise to take advantage of the time value of money and tax-free growth now, especially if you are in a lower tax bracket today compared to your expected tax bracket when you retire.
So essentially the goal is, if you are in a lower tax bracket today than your expected bracket when you retire; the overall tax that you end up paying is much less; since you paid it when you were in your lower tax bracket. In the same matter, the beneficiaries of Roth IRAs don’t owe income tax on withdrawals and can stretch out distributions over many years. However, beneficiaries may still owe estate taxes.
One major difference between Traditional IRAs and Roth IRAs is when the savings must be withdrawn. Traditional IRAs require you to start taking required minimum distributions (RMDs)—mandatory, taxable withdrawals of a certain percentage of your funds—at age 70½, whether you need the money at that point or not. Roth IRAs, on the other hand, don’t require any withdrawals during the owner’s lifetime. If you have enough other income, you can let your Roth IRAs continue to grow tax-free throughout your lifetime, and even after where you can transfer them over to your kids/beneficiaries.
Both Traditional and Roth IRAs allow owners to begin taking penalty-free distributions at the age of 59½. However, Roth IRAs require that the first contribution be made at least five years before the first withdrawal, in order to avoid incurring a tax payment.
With a traditional IRA, there's a 10% federal penalty tax on withdrawals of both contributions and earnings, if you make a withdrawal before the age of 59½. If you are under 59½, you can withdraw up to $10,000 from your account without the normal 10% early-withdrawal penalty to pay for qualified first-time home-buyer expenses and for qualified higher education expenses. Hardships; such as disability and certain levels of unreimbursed medical expenses may also be exempt from the penalty, however, you’ll still pay taxes on the distribution.
In summary, IRAs are great saving/investment tools that help you plan for retirement. If invested correctly, IRAs can be great tax shelters, and will bring you great compounded returns on your investment.