The easiest way to start saving for retirement is through an IRA, but the type of account you choose could make a big difference in the amount of money you receive when you stop working. Traditional IRAs and Roth IRAs are the two most popular types of retirement accounts, but they have considerable differences that every investor should consider before choosing them.
With traditional IRAs, taxes are delayed until funds are withdrawn from the account during retirement. In contrast, with Roth IRAs, you pay taxes up front by contributing money on an after-tax basis and, later in retirement, the funds are withdrawn tax-free (as long as the account has been open for at least five years).
In general, traditional IRAs are more effective if you expect to be in a lower tax bracket when you retire, while Roth IRAs are better for those who are in a lower tax bracket today.
In addition, Roth IRAs are probably better for younger investors who are at the beginning of their careers and therefore expect to have more income (and a higher tax rate) when they retire.
Benefits of IRA Contributions
IRAs accounts stand out as an effective way to save for retirement because of the tax breaks, as well as offering tax-free growth on your investments, so you won’t have to pay taxes on dividends or capital gains while the investments are in your account.
In addition, IRAs are easy to set up and affordable, and are offered at most banks and credit unions, as well as through online brokers and investment companies, and you can make automatic contributions from your checking or savings account.
Another important point is that with an IRA you can choose your investments.
You can also like: What are the Main Differences Between IRA and 401(k) Accounts?
About Early Withdrawals
Withdrawals are less strict with Roth IRAs than with traditional IRAs.
If you withdraw funds from your traditional IRA before age 59 1/2, you will be taxed at the current tax rate and a 10% early withdrawal penalty will apply, whereas with the Roth IRA you can withdraw contributions or earnings:
- Withdrawals of Roth IRA contributions at any age are exempt from taxes and penalties;
- If you withdraw earnings before age 59 1/2, you will incur a 10% early withdrawal penalty and may be subject to income tax, as with a traditional IRA.
On the other hand, Roth IRAs offer a unique advantage that traditional IRAs do not: First-time home purchases, college expenses, and birth or adoption expenses (up to certain limits) count as exceptions to the early withdrawal penalty.
Regarding Contributions and Limitations
Traditional IRAs and Roth IRAs accounts have the same limits, which are set each year: For 2021, the total contribution limit was up to $6,000 if you are under age 50, and up to $7,000, age 50 or older.
Traditional IRAs also offer an advantage that Roth IRAs don’t: Your contributions can be deducted from your taxes each year, up to certain limits. This means you’re rewarded for putting money into your retirement account, as the contributions help reduce the amount you owe in taxes.
The deduction limits for traditional IRAs are as follows:
- Have a retirement plan at work and income at or above $76,000, if single or head of household;
- Have a retirement plan at work and income is equal to or greater than $125,000, if you are married and filing a joint return;
- Have a retirement plan at work and income of $10,000 or more.
Getty Images
Requirements to Open Traditional and Roth IRAs Accounts
The accounts differ in terms of who can open an account, as traditional IRAs can be opened by anyone, regardless of how much money they earn, while there are income limits on Roth IRAs. Let’s look at some of them:
- Married filing jointly or qualifying widow(er): Not eligible if your modified adjusted gross income is $208,000 or more;
- Single, head of household or married filing separately (and you didn’t live with your spouse at any time during the year): Not eligible if your modified adjusted gross income is $140,000 or more;
- Married filing separately (if you lived with your spouse at any time during the year): Not eligible if your modified adjusted gross income is $10,000 or more.
Finally, unlike being limited to your company’s 401(k) plan, with an IRA you can choose your investments and many brokerage firms or banks will help guide you based on their terms until retirement.
Remember, Wave Tax is here to help you organize your finances – contact us at info@wavetax.us