Two common retirement instruments are the Traditional and Roth Individual Retirement Accounts (IRA). There are small differences in both of them that could have a big effect on your retirement dollars. What are the differences and which one is best for you?
The Tax Reform Act of 1986 added the “Traditional” part of the Traditional IRA. However, the “Regular” IRA was created in 1975. The Roth IRA didn’t come about until William Roth proposed the Taxpayer Relief Act of 1997. As mentioned before, there are a few differences between the Traditional IRA and Roth IRA. Although both have tax-deferred growth, money is taxed when it is contributed in the Roth while money is taxed when it is withdrawn in the Traditional. Basically, a Roth pays upfront while a Traditional pays at the backend. Another difference though is that almost anyone earning an income can contribute to a Traditional IRA, but a Roth IRA has income limits. With a Roth IRA, you can withdraw your contributions without penalty, (withdrawing more than your contributions is taxable and subject to a 10% early withdrawal penalty if you are younger than 59.5 years old and have had the plan for less than 5 years) but with a Traditional IRA, you are penalized if you withdraw before retirement.
– Almost everyone eligible – Income restrictions
– Taxed at backend – Taxed Upfront
– Penalized for early withdrawal – Contributions withdrawn without penalty
Now that you have a little understanding of the differences between the two IRA’s, which one is better? Let’s use some quick calculations. Assuming your income level allows you to participate in either, and you will be contributing $1000 each year at 10%. In the Traditional IRA, you contribute $1000 tax-free each year for 20 years. By year 10, you have about $16,000. By year 20, you have about $60,000. Let’s say when you withdraw money, you’ll be taxed at 25%. In a Roth IRA, you contribute $1000 but are taxed $250 each time. Regardless, you are taxed 25% so it turns out to be the same.
They produce the same amount of money. Which is best for you? To determine this, examine yourself and think ahead.
- If you are only eligible for one, your decision is made for you. Yes=Traditional
- Can you afford to pay the taxes on your contributions right now? Yes=Roth Do you think you will be in a lower tax bracket when you retire? Yes=Traditional
- Do you already have a tax-deferred retirement account? Yes=up to you
- Are you afraid to tie your contributions up until you retire? Yes=Roth
As always, talk to a financial planner before making decisions of this magnitude. Financial planners will be able to give you more detail and identify which IRA is right for you.
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