An IRA (individual retirement account) can be your means for a comfortable and financially secure retirement, especially if you’re working in a field that doesn’t offer an employer pension. When starting an IRA, the major decision you’ll need to make is between a traditional IRA or a Roth IRA. Each offers advantages depending on your circumstances, and you’ll need to weigh your options carefully to choose the one best for you.
Choosing When Your Money is Taxed
The key difference between a traditional and a Roth IRA comes down to when your contributions are taxed. In a traditional IRA, contributions are tax-exempt when you make them. This has a couple of ramifications.
First, contributions to a traditional IRA are a way to lower your taxable income in the year you contribute. This may have the benefit of lowering your tax bracket or qualifying you for certain government programs and incentives. But because your contributions to a traditional IRA aren’t taxed at the time you make them, they’ll be taxed on the back end when you withdraw. Note that the withdrawals will be taxed at your current rate, not the rate you had when you contributed.
On the other hand, Roth IRA contributions are taxed before entering the account. That means you’ll be contributing fewer “actual” dollars when making the same contribution to a traditional IRA. But the upside to a Roth IRA is that any future withdrawals are tax-free. That means if you manage to generate a significant sum over a long span of years, a Roth IRA will likely net out to a plus when it comes to taxation.
When assessing the tax benefits of a traditional versus Roth IRA, you’ll need to have a good understanding of your financial outlook at present and in the foreseeable future. If you believe you’ll be able to take advantage of the current lowering of your taxable income, a traditional IRA may be right for you. However, younger people who plan to make contributions over decades are often incentivized to choose a Roth IRA.
Required Minimum Distributions
The term “required minimum distribution” means that a traditional IRA obligates you to withdraw a certain amount of the account each year whether you need the money or not. This begins at age 73 for those born between 1951 and 1959 and starts at 75 for those born after.
Roth IRAs aren’t subject to required minimum distributions. This makes a Roth IRA an attractive tool for passing wealth to beneficiaries without being subject to tax consequences.
Note that one feature shared by both traditional and Roth IRAs is that there are penalties associated with withdrawing money prematurely. With both types, withdrawals before the age of 59 1/2 are subject to penalties, and these penalties will be on top of regular taxation for traditional IRAs.
An IRA can be a tremendous investment vehicle for a comfortable retirement, and choosing the right option between traditional and Roth is crucial to setting yourself up for success. If you’re uncertain, a financial professional can sit down with you and discuss your situation, helping you determine what’s best for you.