If you’re planning ahead for your financial future, Individual Retirement Accounts, also known as IRAs, can offer significant tax benefits. An IRA is a savings account with tax advantages that you can use to save and invest for the long-term, especially for your retirement. There are two main types of IRAs for individuals – traditional and Roth– each with different tax benefits that reward you for saving.
Which type of IRA is right for you? What are some of the benefits? We’ve highlighted a few important facts below to help you decide which options will help you prepare for retirement, save on taxes, access investment options, and give you peace of mind regarding your financial wellbeing.
How do IRAs work?
In a taxable investment account, you have to pay annual taxes on any profits you earn, which can slow the growth of the account. An advantage of establishing either a traditional or Roth IRA is that your earnings aren’t taxed while they’re in the account, which allows your earnings to compound over time. Anyone who has an earned income is able to open an IRA, either through a personal broker, an online brokerage, an investment company, federally insured credit unions, or through a bank (learn about our options here). Individual taxpayers can set up Roth or traditional IRAs, while small business owners and self-employed workers can establish SEP and SIMPLE IRAs.
Earnings that are traditionally eligible for IRA contributions include wages, salaries, tips, bonuses, commissions, and net positive income from self-employment. However some things like union strike benefits, long-term disability benefits, and self-employed income can also be considered earned income by the IRS in certain situations. Earnings from property, interest and dividend income, or any money received as a pension or annuity income, can’t be contributed to an IRA.
While they’re ultimately very different, there are some similarities between traditional and Roth IRAs. Both arrangements can be contributed to by minors (though they must be set up by an adult as custodial accounts) and non-working spouses (as long as they file a joint tax return with their working spouse) provided they meet specific income rules. The annual deadline for making contributions for both is April 15. The majority of the time, both also have contribution limits; the most you can contribute to all of your traditional and Roth IRAs each year is $6,000 if you’re under the age of 50 and $7,000 if you’re over the age of 50.
What’s the difference between a traditional and Roth IRA?
Traditional and Roth IRAs primary difference? When you receive the tax breaks.
If you decide to establish a traditional IRA, your contributions may be tax-deductible in the year during which they are made, though there are upper-income limits on deductibility. If your income is under the limit, you could receive a tax break in the years you contribute to a traditional IRA. However, you’ll eventually pay taxes on money you withdraw from your account during retirement. Basically, opting for a traditional IRA means you’ll pay taxes in retirement, but you may get a tax deduction now.
By contrast, Roth IRA contributions are not tax deductible, meaning you won’t receive a tax break at the time you make contributions. When you withdraw money from the Roth IRA you shouldn’t need to pay taxes on it again during retirement. There are certain situations when Roth IRAs allow tax-free withdrawals on earnings, including for individuals who reach 59.5, are disabled, or use the funds for buying their first home. Basically, choosing a Roth IRA translates into getting a tax break later.
Which type of IRA is better? It depends on your situation.
One of the most important things to consider when deciding between a traditional or Roth IRA is whether you think your tax rate during retirement will be higher or lower than your tax rate during the years when you’re making contributions.
If you think your income and tax rate will be higher now than in retirement, then a traditional IRA might be a better choice for you. A traditional IRA allows you to pay taxes in retirement and take advantage of the lower tax rate rather than paying a higher tax rate. For example, if you plan on paying off your mortgage, putting your kids through college, and not having many expenses by the time you retire, then you’ll probably need less money to maintain your desired standard of living. If you plan on having less income during retirement, then your tax rate may be lower.
If you think your income and tax rate could be higher during retirement, then a Roth IRA may be a better option for you. For example, if you’re toward the beginning of your career and have just started investing, you may expect to pay higher taxes later in your career and into retirement. This can mean years of tax-free growth followed by tax-free income during your retirement. With a Roth IRA, you’re able to withdraw your contributions at any time, though if you withdraw earnings on those contributions, they may be subject to income taxes and penalties
What should you do next?
No one has a crystal ball – not even the IRS – and it can be tricky to predict future tax rates. As a result, many financial experts suggest contributing to both a traditional and a Roth account as a way to diversify your tax savings. Remember, the most important thing is to contribute early and often. And if you are receiving your plan through your employer and they provide some form of matching contribution – always a good opportunity.
Be sure to confirm the IRS income limits and speak to a trusted tax professional before committing to any option. Both traditional and Roth IRAs can help you maximize your retirement savings with tax benefits.
