Let's guide you through the often daunting world of IRAs, so that you can make the right decision for your retirement.
What Is an IRA?
An IRA is an individual retirement arrangement, a tax-advantaged savings and investment instrument designed, as the name implies, to help people save money for retirement. An IRA allows you to invest with favorable tax treatment. In fact, taxation is the key difference between a Traditional and a Roth IRA.
How Do a Roth and a Traditional IRA Differ?
The essential difference between Roth and Traditional IRAs is the timing of taxation - taxes are paid either as money goes into an IRA, or as it comes out. Roth IRAs are funded by your after-tax income, so you will not pay taxes on withdrawals or disbursements post retirement. In contrast, Traditional IRAs are funded with pre-tax income; instead of paying taxes upfront, you pay taxes on the money after retirement, as you begin to make withdrawals.
What Are the Comparative Benefits of Each?
Additional, though less significant, differences exist. These include:
- Growth in a Roth IRA is tax-free, while taxation on investment growth in a Traditional IRA is merely deferred until you make withdrawals.
- With a Traditional IRA, once you hit 70 ½, you are subject to Required Minimum Distributions (RMDs) - you are required to begin withdrawing money. With a Roth IRA, in contrast, you are never subject to RMDs.
- There is no income limit for eligibility to enroll in a Traditional IRA. Eligibility for a Roth IRA, however, depends on your adjusted gross annual income. If it’s above a certain threshold, you may not be able to contribute to a Roth.
When comparison shopping for the best retirement plan for you and your family, the above aspects of the two main IRA schemes are important to keep in mind. See detailed comparison chart below:
|Roth IRA||Traditional IRA|
any age, with taxable employment compensation
- Income: income must be below a certain threshold to make contributions
under age 70.5, with taxable employment compensation
- Income: No income limits to make contributions
|Contribution Limits||- Age <50: $5,500 per year
- Age 50+: $6,500 per year (capped at level of taxable compensation)
|Tax Benefits||- Tax-free earnings growth
- Tax-free withdrawals
|- Tax-deferred earnings growth
- Typically tax deductible contributions (up to a limit if total earnings are above a certain level)
|Taxation at Withdrawal||- Contributions are never taxed upon withdrawal Earnings are tax-free (at the federal level) after 5 years and certain other conditions are met||- Withdrawals of pre-tax earnings and any investment income are taxed upon distribution|
|Required Minimum distributions (RMDs)||None||Beginning at age 70.5|
So, Which Retirement Instrument Is Right for Me?
Deciding which retirement instrument is appropriate for you, your family, and your future can be challenging. For the sake of simplicity, you can boil it down to a question of current versus future tax rate. If you believe you are likely to be in a higher tax bracket when you retire, the Roth IRA usually is the best choice. If, on the other hand, you expect to be in a lower tax bracket when you retire, a Traditional IRA likely is a better option, as the tax deduction now, when your tax rate is higher, is more valuable.
Are There Other Kinds of IRAs?
Oh yes. Here are the two most common:
- SEP IRAs (Simplified Employee Pension IRAs) are a variation of IRA suited to self-employed individuals and small business owners
- SIMPLE IRAs (Savings Incentive Match Plan for Employees IRAs) are similar to 401(k) plans, but suitable for smaller companies that cannot afford the administration costs associated with the 401(k)
Both of the above are worth looking into if you own a business or are a sole proprietor.