September 6, 2012
Traditional IRA vs. a Roth IRA
Regardless of how much the economy struggles, men and women will always have an eye toward their retirements. Saving for retirement might be more difficult in a bad economy, but that doesnít mean such saving should not remain high on an individualís priority list.
One of the more popular ways men and women save for retirement is via an IRA, or an Individual Retirement Account. Contrary to popular belief, an IRA is not an investment but essentially a savings account with considerable tax breaks. Unlike a 401(k), IRAs are commonly opened by individuals acting on their own and not through their company, though self-employed individuals and small business owners can open an IRA.
When it comes to choosing an IRA, many people choose between a traditional IRA and a Roth IRA. For those unfamiliar with IRAs, there are differences between the two.
What is a traditional IRA?
A traditional IRA is a tax-deferred account, and account holders only pay taxes on their money when they make withdrawals in retirement. When taxes are deferred, all of the accountís dividends, interest payments and capital gains are allowed to compound each year without being taxed. This allows the account to grow considerably faster than a taxable account.
Most people can open a traditional IRA, but there is a qualification. An account holder or an account holderís spouse must earn taxable income and be under the age of 701/2 to contribute to a traditional IRA. Thatís the easy part.
Determining if the contributions to a traditional IRA are tax deductible gets a little tricky. Much of this depends on an individualís income and whether or not he or she is offered a 401(k) or other retirement plan at work. The guidelines that govern if contributions are tax deductible change from year to year, so people should familiarize themselves with these guidelines before opening an account.
What is a Roth IRA?
A Roth IRA allows money to grow tax-free. This is because a Roth IRA is funded with after-tax dollars that men and women have already paid taxes on. The benefit here is that the money in a Roth IRA grows tax-free and, upon being withdrawn, no additional taxes are paid.
Many men and women prefer a Roth IRA over a traditional IRA because the former is more flexible with regards to withdrawals. A Roth IRA allows account holders to withdraw their contributions penalty-free at any time for whatever reason they choose. However, account holders cannot withdraw investment earnings before age 591/2 unless the reason for the withdrawal is exempt. If not, account holders might have to pay a 10 percent tax penalty. Penalty-free withdrawals can be made for a number of reasons, including paying medical expenses greater than 7.5 percent of adjusted gross income, paying for a first-time home purchase and paying for costs of a sudden disability. Before opening a Roth IRA, individuals should familiarize themselves with all the rules and restrictions that apply, including which withdrawals are penalty-free and which incur a penalty.
Men and women who choose a Roth IRA can also continue making contributions after they have turned 701/2, whereas traditional IRA account holders cannot continue making contributions after the age of 701/2. Whatís more, men and women who have a Roth IRA are not required to begin making withdrawals once they reach age 701/2 as they would be with a traditional IRA.
Choosing between a traditional IRA and a Roth IRA depends on the individual and their income potential, specifically, which tax bracket they expect to be in upon retirement. Money can be converted from a traditional IRA into a Roth IRA, but that money cannot be withdrawn for at least five years without incurring a penalty. Before making a decision, men and women should consider discussing their options with a financial advisor to ensure they make the best decision for them.