Individual Retirement Accounts, or IRA’s, are savings vehicles that offer tax benefits and the ability to invest in the stock market. The two most popular IRA’s are the Traditional and Roth IRA. The Traditional IRA originated in 1974, but the Roth IRA didn’t come along until 1998. Below are the key differences between the two accounts as well as how they can help you plan for retirement.
Traditional and Roth IRA Tax Differences
The most important difference between a Traditional IRA and Roth IRA are how the accounts are taxed. The Traditional IRA allows individuals to contribute pre-tax dollars, which may lower their gross income in the year of contribution. When you invest your contribution in the market, it grows tax-free. Once you withdraw from the account, the entire withdrawal is taxed like ordinary income.
Please note: Deductibility of contributions to a Traditional IRA depends on whether an individual is a participant in a qualified retirement plan and if their income is under certain limits.
The Roth IRA is essentially the opposite. Instead of receiving a tax deduction on your contributions, you contribute with “after-tax” dollars (what you bring home). Your invested contributions also grow tax-free, but upon withdraw, there are no tax consequences (assuming you followed the withdrawal rules).
Here’s an example:
Let’s assume you invested $6,000 into a Traditional IRA in 2021 and it grew to $12,000 by the time you retired. When you withdraw that $12,000, it will increase your taxable income by $12,000 in the year of withdrawal. Whereas if you invested that $6,000 into a Roth IRA, the $12,000 withdrawal would not impact your taxable income at all.
Required Minimum Distributions
Another key difference between the two accounts are the Required Minimum Distribution rules, or RMD’s. In the year you turn 72, you are required to withdraw a certain amount of your Traditional IRA each year. This is the government’s way of essentially forcing individuals to pay taxes on their Traditional IRA accounts. Unlike the Traditional IRA, Roth IRA’s do not have required minimum distributions. In theory, you could go your entire life without taking a distribution from your Roth IRA if you wanted too.
When Should I Consider an IRA?
I’m sure you’ve heard the old saying “better now than never.” This applies when it comes to saving for your future retirement. Whether your 55 or 25, it’s important to start now! It’s also important to know that just putting your money into a savings account or CD is like losing money. The interest on those accounts will not keep up with inflation, therefore, it’s crucial to start investing in the market and giving your money a fighting chance.
There are many different rules regarding how much you can contribute to an IRA, who’s eligible to contribute, allowable withdrawals, and much more. You should consult your financial professional before opening a Traditional or Roth IRA to ensure it’s appropriate for your financial situation.
Curious about whether a Traditional or Roth IRA may benefit you? Give us a call! https://partnersinfinancialplanning.com/contact/lets-talk/
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