The ABCs of IRAs: How to Choose the One Right For You
The pandemic had lasting financial consequences for many Americans. For example, many people dipped heavily into their savings to weather job losses or reduced wages.
One upside is that it also encouraged people to think long-term about their finances. In particular, people who might not have given much thought to retirement began considering things like types of IRA, such as a traditional vs Roth IRA.
If you’re still hazy on what differentiates these types of IRAs, keep reading for a breakdown of their essentials and benefits.
What Is a Traditional IRA?
With a traditional IRA, you contribute pre-tax income into an investment account. That money in the account is typically managed by a bank that uses it, along with money from other IRAs, to invest in stocks, bonds, real estate, and related financial products.
Assuming the bank manages the investments carefully, the value of the account grows over time and gives you income in your retirement years. Most traditional IRAs set distribution minimum ages at around 59.5 years old and mandatory distribution at 72 years old.
For more information about traditional IRAs, you can consult with a retirement planning business such as Bogartwealth.com.
Benefits of a Traditional IRA
The main benefit of a traditional IRA is that it lowers your adjusted gross income for the year that you make your contribution. That can potentially alter your tax bracket. It will reduce your tax load somewhat for that year.
The tradeoff is that your future withdrawals get treated as taxable income at your tax rate for that year. If you know that your tax rate will be lower in the future, that is an advantage. Determining your future tax rate is typically very difficult, particularly early in adulthood.
Traditional IRAs also impose no income limits.
What Is a Roth IRA?
A Roth IRA shares some similarities with a traditional IRA. It’s an investment account that should, when properly managed, accrue wealth for you over time. Once you retire, you can start taking distributions from the account.
You fund your Roth IRA with post-tax income, which means you invest money that you already paid state and federal taxes on. Roth IRAs impose income limits on who can contribute.
Benefits of a Roth IRA
Roth IRAs offer several benefits. Standard distributions are tax-free. You avoid mandatory distributions ages.
You can also withdraw your actual contribution funds from a Roth IRA without penalty starting five years after your first contribution. While not ideal, it can provide a financial safety net for you.
Traditional vs Roth IRA
The traditional vs Roth IRA debate will likely rage on for years to come. In reality, though, the difference largely boils down to when you want to pay your taxes on your income.
If you think you’ll get a better tax rate in the future, a traditional IRA makes the most sense. If you prefer paying your taxes now, a Roth IRA is the way to go.
Looking for more personal finance tips? Check out the posts in our finance section.