Traditional vs. roth iRA-which is right for you?
An IRA (Individual Retirement Account) is a tax-advantage investment tool that allows you to save money for retirement. There are two types of IRAs: Traditional and Roth. While they are similar, they differ mainly based on when the individual pays taxes. Which IRA you choose may depend on your plans for the future so be sure to review both options.
Traditional iRA
With a traditional IRA, you contribute to this fund from your gross salary, pulling from income that has not been taxed yet. Earnings in this account grow tax-free. Taxes are only paid upon withdrawal. Because many retirees find themselves in lower tax brackets later in life, they prefer this option because the money they contribute will be taxed at a lower rate.
Benefits:
- There are no income limits to contribute.
- You may be eligible to deduct your contributions from your earned income on your taxes (see contribution limits below).
- You can use up to $10,000 towards the purchase of your first home (you’ll owe taxes on the money withdrawn but not a penalty).
Watch outs:
- Should you withdraw before the minimum age (59.5), you are subject to a 10% penalty. You are required to begin withdrawing funds at age 72.
Roth IRA
The Roth IRA is almost the opposite; you contribute funds that have already been taxed and you experience tax-free withdrawals upon retirement.
Benefits:
- There is no minimum distribution requirement so you can withdraw your contributions at any time without penalty. However you will still be taxed and penalized on the earnings.
- Withdrawals from a Roth do not count as taxable income, so withdrawing funds won’t bump you up into a higher income bracket.
Watch outs:
- Because you are allowed to withdraw your contributions without penalty, this may not be a great option for those who are not very fiscally disciplined.
Why do you need an IRA?
Experts estimate that you will need 85% of your “pre-retirement” income upon retiring. For example, if upon retiring at 65 you make $100,000, consider $85,000 to be your necessary retirement income to maintain your lifestyle. 401ks, while great savings tools, have annual caps ($19,500) and may not be enough to sustain your financial needs. If your 401k alone nets you a savings of $500,000, that means, if you plan to live another 20 years post retirement, you are living on only $25,000 a year (pre-tax) assuming you have no other savings. An IRA can help supplement that retirement income.
What are some of the restrictions?
Similar to a 401ks, IRAs come with certain restrictions.
For both the Traditional and the Roth, the maximum contribution is fairly low capped at $6,000 annually which is why it’s recommended as a supplement to the 401k. If you’re 50+, you are allotted an additional +$1,000 as a “Catch up” contribution.
Roth IRA: For the Roth IRA, how much money you make will limit how much you can contribute. At a higher income bracket, the amount you can contribute begins to decline until you are no longer allowed to contribute, making Roth IRAs a great option for lower income earners or people starting out in their careers.
If you file as a single earner, your max income limit is $139,000 ($206,000 for a joint file).
Traditional IRA: There are also some restrictions on a traditional IRA specifically related to your other retirement plans. If you’re covered by a work sponsored retirement plan like a 401k, your ability to deduct IRA contributions may be reduced or eliminated entirely at higher incomes. You can still make contributions regardless of income, but at a certain point they won’t be tax deductible.
For example, if you are already participating in an employer sponsored 401k, you must be making less than $65,000 to take the full deduction ($104,000 if filing joint). Once you make over $75,000 ($124,000 if filing joint) you can no longer deduct the contribution on your earned income.
which is right for me?
A Roth IRA makes more sense for someone who plans to be in a higher ta bracket upon retirement since their funds will have been taxed at a lower rate upon contributing. Overall it’s a great option if you meet the income criteria noted above. Because there are income limits on the Roth IRA, going for a traditional IRA is a no brainer for some. Should you expect to retire in a lower income tax bracket, the traditional IRA is the better choice as you’ll be paying lower taxes on the contributions overall.
Be sure to consult with a tax attorney and/or financial advisor before making any withdrawals or changes to your IRA.