Deciding whether to contribute to a Roth IRA or a Traditional IRA can be tough. Both have their pros and cons, and it ultimately comes down to what makes the most sense for your individual financial situation. In this blog post, we'll break down the key differences between Roth IRAs and Traditional IRAs so that you can make an informed decision about which is right for you.
Roth vs Traditional IRA: The BasicsThe biggest difference between Roth IRAs and Traditional IRAs is how they're taxed. With a Traditional IRA, you get an upfront tax deduction for your contributions, but you're taxed on all withdrawals (including earnings) in retirement. With a Roth IRA, you don't get an upfront tax deduction, but all withdrawals (including earnings) are tax-free in retirement.
Roth vs Traditional IRA: The DetailsNow let's take a closer look at each type of IRA in more detail.
Traditional IRA: With a Traditional IRA, you can contribute up to $6,000 per year ($7,000 if you're age 50 or older). If you're covered by a workplace retirement plan (like a 401(k)), then your contribution limit may be reduced or eliminated altogether. Contributions to a Traditional IRA are typically tax-deductible, which means they lower your taxable income for the year. For example, if you contribute $5,000 to a Traditional IRA and your marginal tax rate is 25%, then your taxes owed for the year will be reduced by $1,250 ($5,000 x 25%).
Withdrawals from a Traditional IRA are taxed as ordinary income. So if you withdraw $20,000 from your account during retirement and your marginal tax rate is 25%, then you'll owe $5,000 in taxes ($20,000 x 25%). You can start taking penalty-free withdrawals from a Traditional IRA as early as age 59 1/2 . If you withdraw money before that age, you'll typically owe a 10% early withdrawal penalty on top of any taxes owed.
Roth IRA: With a Roth IRA, there's no upfront tax deduction like there is with a Traditional IRA. However, all qualified withdrawals (including earnings) are completely tax-free in retirement. To be eligible for tax-free withdrawals in retirement, you must hold the account for at least 5 years . Contributions to a Roth IRA are not limited by how much you earn; anyone can contribute as long as they don't exceed the contribution limit ($6,000 per year/$7,000 per year if age 50 or older). Because contributions to a Roth are made with after-tax dollars , that means you won't owe any taxes on them when you make withdrawals in retirement. For example, if you contribute $5,000 to a Roth and withdraw it during retirement, then the entire $5,000 is yours to keep; you won't owe any taxes on it. You can start taking penalty-free withdrawals from earnings on your contributions as early as age 59 1/2 . If you withdraw money from your account before that age (and it's not for a qualifying reason), then you'll typically owe a 10% early withdrawal penalty on top of any taxes owed.
Both Roth IRAs and Traditional IRAs have their pros and cons. Ultimately it comes down to what makes the most sense for your individual financial situation. If you think there's a chance you'll be in a higher tax bracket in retirement than you are now , then contributing to a Traditional IRA may make more sense because it offers an upfront tax deduction . On the other hand , if you think your marginal tax rate will be about the same or lower in retirement than it is now , then contributing to a Roth may be the better choice because it offers tax-free withdrawals in retirement . No matter which type of account you choose , remember that both offer the potential for significant growth over time , so make sure to start contributing sooner rather than later!