When the idea of saving for retirement comes up, many people wonder whether a Roth vs Traditional IRA is better for them. There are many similarities between these two investment vehicles, but there are also enough differences to make this question a little more difficult than it seems.
We will look at some of the similarities and differences of these Individual Retirement Arrangements
Roth Vs Traditional IRA
Both a Roth and Traditional IRAs can be great options when it comes to saving money for retirement and a viable alternative to private or stakeholder pension plans. Before we take a look at Roth IRAs, let’s look at a couple of quick points regarding traditional IRAs, so you can better decide which may be the best retirement plan for you.
One of the greatest benefits of a Traditional IRA is the fact that your contributions can grow freely, with the taxes that you owe being deferred until the money is distributed. This means that you receive the benefit of compound interest on all of our contributions, gains, and other earnings!
In most cases, the contributions that you make into a traditional IRA are fully or partially deductible – depending on your circumstances. That means that your taxable income is reduced by the amount that you contribute to a traditional IRA (if it is fully deductible).
An IRA usually provides more freedom than an employee sponsored retirement account when it comes to your investment options. You can invest in individual stocks, bonds, mutual funds, CDs, and even real estate! This helps to make an IRA an extremely attractive retirement vehicle.
Here is something that is usually seen as a negative feature of a traditional IRA. According to the IRS:
You cannot keep funds in a traditional IRA indefinitely. Eventually they must be distributed. If there are no distributions, or if the distributions are not large enough, you may have to pay a 50% excise tax on the amount not distributed as required.If you are the owner of a traditional IRA, you must generally start receiving distributions from your IRA by April 1 of the year following the year in which you reach age 70½.
That’s right – if you do not start withdrawing money from your account, the IRS will charge a 50% tax on the amount that should have been distributed! Before you become too outraged, remember that you received a tax deduction on your contributions, and you are not required to pay taxes on any gains until they are distributed. If you kept the money in your account indefinitely, it would never get taxed…there is no way that Uncle Sam will allow that!
You can read IRS Publication 590 (link to online version) in order to gain more information about Traditional IRAs, including calculating the required minimum distribution.
In looking at the “battle” of Roth vs traditional IRAs, there is no need to compare the investment opportunities since they are exactly the same. Unlike their counterparts, Roth IRAs do not give you a tax deduction upfront. This means that you will have to reach the IRA contribution limits with without the benefit of reducing your taxable income for the year.
Like the traditional IRA, your contributions, gains, and earnings will grow without being taxed – allowing compound interest to kick in! However, since your initial contributions were made with taxed dollars, you do not have to pay taxes when you take a qualified distribution from the account!!!
What this means is once you put money into a Roth IRA, you will never have to worry about paying taxes on that money (as long as you satisfy the requirements). For one thing, you have to keep your contributions in the account for at least five years before you can withdraw them with no penalty. Of course, since it is a retirement account, keeping the money invested for more than five years shouldn’t be a problem.
Another thing to consider with Roth IRAs is that you can make contributions to the account even after you turn 70 1/2 (something which you cannot do with a traditional account). On top of this, you are also able to leave amounts in your ROTH IRA for as long as you live. There are no required minimum distributions, and no taxes assessed for failing to make withdrawals – since the initial contributions were already taxed.
Roth Vs Traditional IRA – What’s Best For You?
Here is one of the keys to consider when trying to answer this question:
At what stage in your life will you be paying lower taxes? If now, then go with a Roth and pay lower taxes on your contributions, rather than paying taxes on your distributions when you are paying at a higher rate. If your lower taxes will come in retirement, then go with a Traditional IRA to get the tax break when your taxes are higher, and pay taxes on your contributions once you are in a lower bracket.
There are a couple of things that will affect your tax rate both now and in retirement.
- The tax code – will future administrations raise taxes in order to pay for government spending?
- Your income – will you have more taxable income now or in retirement? The answer isn’t as obvious as it might seem.
- The amount in your retirement accounts – if you have a take several required distributions from large accounts, that can easily push you into a higher tax bracket.
There are other things to consider but since they are pretty much impossible to quantify, we will leave them for another discussion.
- Based on your situation, which IRA is best for you?
- What do you think about having one of each?
- At what point did you/will you start saving for retirement?
This post is a part of the Roth IRA Movement that my blogging buddy Jeff Rose at Good Financial Cents put together. The last time I checked, there are almost 150 websites that will be posting about the benefits of Roth IRAs! Even though the information is pretty standard, I am confident that each post will be different, because of the voice of the individual writing it! You can read my other post (which takes a more personal and informal look at this question) on my weight loss and debt repayment site here: Why Roth IRA is better than Traditional for us
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