Planning for retirement is important, and you may find all of the options out there overwhelming. First developed in 1974 and 1997, respectively, the purpose of an individual retirement account (IRA) is to promote long-term savings and investments.
There are two common types of IRA accounts: the traditional IRA and the Roth IRA.
Though these two plans are very similar, the most notable difference is the tax advantages. With a traditional IRA, your taxes are lower while you work and make contributions. Once you are 59 ½ or older, you can withdraw your amassed funds penalty-free. With a Roth IRA, your funds are tax-free, and you can take them whenever you want.
Read on to learn more about what encompasses a traditional IRA, what a Roth IRA is, and how these plans compare.
Key differences between a traditional and Roth IRA
Broken down below are the main features that define both a conventional IRA and a Roth IRA.
As of 2021, the maximum annual contribution for a traditional IRA is $6,000 every year. This increases to $7,000 if you’re over the age of 50. The same limits apply to Roth IRA contributions.
If you withdraw your retirement savings before age 59 ½ from a traditional plan, you will face a 10 percent penalty on the amount you withdraw. There are some exceptions to this rule.
Traditional IRA withdrawals are considered regular taxable income by the government, and you must withdraw these funds after age 72.
Roth IRAs offer tax-free withdrawals and you can withdraw your savings whenever you’d like once five years pass after your first contribution.
Traditional IRA contributions are tax-deferred, meaning your contributions have tax-free growth and are deductible. You’ll have to pay taxes when withdrawing the money after retirement, though.
With a Roth IRA, you don’t receive any tax deductions while still in the workforce, meaning that your contributions are taxed. If you’re in a higher tax bracket, you’ll pay more to have a Roth IRA as you’re depositing income. However, once you retire, you won’t have to pay taxes on your withdrawals.
Generally, a traditional IRA is better suited for individuals in a lower tax bracket. Roth IRA funds may be more appropriate for higher income individuals because these parties can typically afford the added monthly taxes.
However, anyone who earns a working wage can contribute to a traditional IRA. Roth IRAs have restrictions based on income and relationship status. As of 2021, single individuals can add money to their Roth savings plan as long as they have a modified adjusted gross income (MAGI) of $140,000. Married couples must make less than $208,000 or they won’t be eligible for the Roth plan. The Roth IRA targets a smaller demographic because of its income limits.
Remember, the contribution amounts are identical to the traditional plan; they’re simply taxed when deposited, not withdrawn. These limitations have been put in place to try and make the playing field more equal between employees.
The main question you should consider in choosing between a traditional IRA and a Roth IRA is whether you’d rather receive your tax benefits now or in the future.
Special considerations for a traditional and Roth IRA
Those with permanent disabilities and certain medical expenses don’t have to pay the early withdrawal penalty on any IRA.
When deciding which type of plan is best for you, your biggest consideration should be which income tax bracket you qualify for. You’ll have to take the time to figure out whether you’ll pay more in taxes if you choose to take a break now or down the road. It all comes down to when you’d prefer to reap the benefits.
You’re permitted to contribute to both types of savings accounts, but this can be costly as you’ll be setting aside double the savings. This may be wise if you don’t know what your tax situation will look like later on. Don’t be afraid to consult a financial planner or another professional for a second opinion.
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