Opening an IRA is a great way to save for retirement because it gives you the opportunity to make tax advantaged contributions which may produce larger gains than investing in an account without similar tax advantages (where are the best Roth IRA rates?). Most people are eligible to open Traditional and Roth IRAs, and depending on your financial situation, one of the two may be better than the other.
Comparing Traditional and Roth IRAs
Both a Traditional IRA and Roth IRA have certain tax advantages that make them good options for your retirement investments. The main difference is that a Traditional IRA is a tax deferred retirement plan, and a Roth IRA is a tax exempt retirement plan.
How Traditional and Roth IRAs work
The main difference between the two individual retirement plans is when you pay taxes on the money and when/if you are required to make minimum distributions.
How Traditional IRAs Work. Traditional IRA contributions are made with pre-tax money which will grow without taxes until you make withdrawals in retirement age, or under certain circumstances. The tax benefit will be recorded when you file your taxes next year, usually by reducing your taxable income by the amount of the contribution if you are eligible to contribute to a tax deductible Traditional IRA based on your income.
To find out if you are eligible for tax deductible contributions check out the IRA contribution limits. Withdrawals from Traditional IRAs are taxed at the time of distribution. Traditional IRAs are also subjected to required minimum distributions starting at age 70½, regardless of whether or not you feel the need to make withdrawals.
Beware of early withdrawal penalties. Making withdrawals before you reach retirement age may subject you to early withdrawal penalties, which can cost you a 10% penalty and you have to immediately pay taxes on the amount you withdraw. So you can end up losing a large portion of your retirement fund by making early withdrawals.
How Roth IRAs Work. Roth IRA contributions are made with money that has already been taxed and contributions are not tax deductible when you make them. However, since the contributions were made with money that has already been taxed qualified distributions can be made tax free. There are no required minimum distributions for Roth IRAs, which gives you more flexibility in retirement. Please see the links above for Roth IRA income and contribution limits for more information about Roth IRA eligibility. Early withdrawal rules still apply, however, there are certain other tax rules that permit withdrawals for events such as buying your first house, paying for college and certain other events. Please visit the IRS website or contact a tax professional for more details.
Which is better Traditional or Roth IRA?
Investing with a Traditional or Roth IRA gives you the opportunity for tax diversification and more flexibility in retirement. There are many factors to consider when comparing Roth and Traditional IRAs, including your current tax bracket and your expected tax bracket in retirement. You also need to consider current income, Roth or Traditional IRA eligibility, contribution limits and required minimum withdrawal requirements. Tax free Traditional IRA contributions phase out at lower income levels than Roth IRAs, so you may consider a Roth if you cannot receive the tax deductions from a Traditional IRA. There are also minimum withdrawal requirements for Traditional IRAs, while Roth IRAs do not have a required minimum distribution.
Which is better? Many financial experts recommend Roth IRAs if you are eligible because they offer tax free withdrawals and other benefits such as higher income levels for eligibility and no required minimum distributions. Overall, they offer more flexibility than Traditional IRAs.
Opening an IRA. Here is more information about what to look for when opening an IRA.