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If you’re funding an Individual Retirement Account, your first decision will be a Roth vs. traditional IRA.
But what’s a Roth IRA? And what are the differences between a Roth and a traditional IRA?
In this article, I’ll explain the tax implications, which are the biggest differences between contributing to a Roth IRA vs. a traditional IRA. I’ll also give you some guidance on when each choice makes sense.
An IRA is an Individual Retirement Account. They’ve been around for almost half a century now. Roth IRAs, which have been available since 1997, hold some similarities to traditional IRAs.
The biggest difference is the treatment of taxes.
When you contribute money to a Roth IRA, you’re putting in money that you have already paid taxes on. When you withdraw money from a Roth IRA in retirement, you won’t owe any taxes on the money you put in or the profit you’ve made.
If you think that taxes will rise in the future, paying taxes now and then taking your money out later — tax free — is a win.
That’s why money expert Clark Howard prefers Roth IRAs over traditional IRAs.
“Remember, in general, tax rates are likely to go higher over the years no matter which political party is in power,” Clark says. “That means it may make more sense to skip the deduction of a traditional IRA now to avoid tax later with a Roth IRA.”
Imagine that Susan and Jim make the same amount of contributions to their IRAs, but Susan has a Roth and Jim has a traditional IRA.
Assuming that their contributions and profits are equal, when Susan and Jim reach the penalty-free withdrawal age of 59½, Susan is going to have more retirement money. That’s because Jim is going to have to pay taxes on his withdrawals.
There are two hurdles you have to clear to withdraw investment earnings from a Roth IRA without penalty:
That five-year rule is unique to Roth IRAs. How do you know when your Roth reaches its fifth “birthday?” The clock starts on the earliest date of these three events:
If you’re younger than 59½, and your Roth IRA includes money from multiple conversions, you must track each conversion separately to calculate the five-year holding period.
It is worth noting that while you do have to clear these hurdles to take out your earnings to avoid a hefty penalty, you can take out your principal (the money you put in) at any time penalty-free. That’s not to say you shouldn’t have savings for emergencies, but for some people knowing this is enough to help them start saving for retirement.
Roth | Traditional | |
---|---|---|
Best for | Expect taxes to rise in the future | Expect taxes to be lower in the future |
Taxes | Grows tax-free; contributions not deductible | Grows tax-deferred; contributions tax deductible subject to income limits for participants in employer-sponsored plans |
Contributions | Post-tax dollars | Pre- or post-tax dollars |
Contribution limits | $6,500/$7,500 | $6,500/$7,500 |
Contribution eligibility | Earn income below certain limits* | Earn income* |
Withdrawal | Tax-free after 5 years + age 59½^ | Taxed as income after 59½ |
Required Min. Distribution | Never | After 73# |
Bottom line | Celebrate future tax-free withdrawals | Reduce taxable income + no immediate taxes |
*You also can’t contribute more than 100% of your income for the year.
^The 10% early withdrawal penalty applies only to your investment earnings. You can take out your contributions at any time with no penalty.
#You must take your first RMD by April 1 the year after you turn 73. In subsequent years you must take your RMD by Dec. 31.
Let’s cut to the chase. Figuring out Roth vs. traditional IRA comes down to figuring out whether your taxes are going to be higher now or higher when you withdraw the money.
If you want to run some numbers yourself, check out our Roth vs Traditional IRA calculator.
Most people assume their tax brackets will be lower in retirement, and that may be true. But don’t discount Social Security income, income from traditional 401(k) plan withdrawals, income from any consulting or freelance work and the loss of certain tax deductions such as those for dependents or a mortgage.
Clark thinks that almost everyone will pay higher taxes in the future to finance the federal government’s current budget deficits. That’s why he’s so pro-Roth.
Roth and traditional IRAs do share plenty of attributes:
Here’s when a Roth IRA may make more sense for you:
Here’s when a traditional IRA may make more sense for you:
The contribution limits of IRAs are relatively low. You’re allowed to put in $6,500 per year (which works out to $541 per month) if you’re younger than 50. That’s compared to $22,500 per year with a 401(k).
IRAs also don’t allow you to get company matches. That’s one of the major advantages that 401(k) plans offer.
However, you’ll have way more investment options inside of an IRA (including investing via a robo-advisor). You’ll also potentially enjoy lower costs. And you’ll probably experience a lot less hassle in the future, especially if you leave a job where you have a 401(k) plan well before retirement.
Clark recommends that the first thing you do — before opening any type of IRA — is to contribute enough to your 401(k) to get the maximum company match from your employer (if a 401(k) is available to you).
Clark says that unless your 401(k) plan is expensive, you should contribute to your 401(k) up to your annual contribution limit before turning to an IRA.
If you plan to open an IRA, Clark recommends that you do so with one of the Big Three investment firms. That means Fidelity, Schwab and Vanguard.
Whether you choose a Roth or a traditional IRA, Clark says it’s important to:
Clark recommends Roth IRAs over traditional IRAs because he thinks that taxes are going to rise in the future.
Just remember that time in the investment market, especially inside a tax-advantaged account, is a powerful force that can help you achieve your retirement goals. That goes for all types of retirement accounts — Roth vs. traditional IRAs and 401(k)s.
This post was last modified on April 2, 2024 12:40 pm
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