In retirement, it is important to know the differences between Traditional IRAs and Roth IRAs so you do not have an enormous tax bill. The consequences of picking the wrong one could add up to thousands down the road, while picking the right one will allow you to keep more of your money for yourself.
The Main Idea: Two Types of Accounts With Two Different Tax Timelines
Traditional IRAs and Roth IRAs are both types of retirement accounts that allow for growth of funds through investment in stocks, mutual funds or other investments over time28; however, there are significant differences between the two accounts in regards to tax payment timing.
Traditional IRAs are funded with pre-tax dollars, which means you receive a tax deduction for making the contribution and it reduces the taxable income for that year and stores money in the account. When you retire and begin taking money out, you will pay ordinary income tax on the dollar amount taken out of the account from all investments and interest accrued.
Roth IRAs are funded with after-tax dollars, meaning although you do not receive a tax deduction for making a contribution, when you retire and take out money from the account all contributions including income earned through investments will not be subject to taxes.
Basically it is a trade-off, do I pay less tax on the contribution today and more tax when you take the money out, or do I pay more tax on my contribution today and no tax when I take the money out?
How Compounding Interest Affects Things Differently
Over several years, the majority of your retirement account will be attributed to investment appreciation of your contributions.
With an individual retirement account (traditional IRA), you will pay taxes on your appreciation when you withdraw funds from the account, while on the other hand, if you invest in a Roth IRA, you will not be taxed on your appreciation; however, taxation is only deferred until you reach retirement. If your account grows through compounding interest, the difference between these two types of accounts will be significant.
Income Limits Can Result In People Who Earn High Incomes Losing Benefits
Not everyone will receive the same benefits when it comes to contributions and withdrawals from either type of account. If you earn a high income, you may lose the tax benefits of contributing to a traditional IRA. If your income is extremely high, you may not qualify to contribute to a Roth IRA directly.
However, there are many high-income earners who use a backdoor Roth to legally create a Roth IRA to take advantage of the benefits associated with both types of accounts. If you fall under this category of earners, consider researching this topic further if you are considering a backdoor Roth conversion.
What to Expect When Withdrawing Money
Traditional IRA
If you withdraw from your account prior to reaching age 59 ½, you will incur both taxes and penalties.
If you reach age 72, you will be required to begin taking money from the account as part of the Required Minimum Distribution provisions of the IRS.
Roth IRA
You may take withdrawals of the original contributions at any time without incurring any penalties.
There are no required minimum distributions for you to make as a Roth IRA account owner.
Continuously growing your account until you die is allowed without being required to distribute funds after reaching retirement age for you or any beneficiary of the account.
Flexibility is one reason Roth accounts are so popular.
Contributions are Still Limited
You can only contribute so much to either type of account in any given year; anyone over 50 has a slightly higher contribution limit.
Until the next tax return is due, you can make contributions to either account based on the previous year, giving you flexibility in your planning.
The Author’s Opinion
If you had to pick one account, most people would lean to a Roth IRA. It’s not perfect; however, it provides a tax benefit at retirement, so you could substantially accumulate wealth without paying any taxes down the line.
Roth vs. Traditional Isn’t the Key Learning
The most important thing you can do is get started early, make regular contributions, and stay invested.
Pension plans are rare, and social security is uncertain; retirement will, for the majority, depend on the individual’s ability to save and invest appropriately.
No matter what type of retirement strategy you use (a Traditional, Roth, or a combination of both), understand the rules first. This will make your transition to retirement much smoother for you and allow you to concentrate on enjoying your life now.
One day, when you no longer need to work for a living, your retirement investments will provide the income that creates that financial freedom.
