There are two main types of IRAs: the traditional IRA and Roth IRA. The names may sound similar, but there are major differences between a Roth and a traditional IRA.
Before we dive into the differences, first lets take a look at some of the similarities.
What is an IRA?
IRA stands for Individual Retirement Account. They’re exactly what they say on the tin, accounts designed to help people sock money away for the end of their career.
Both Roth and Traditional IRAs:
- Provide tax benefits to contributors
- Allow you to qualify for the saver’s credit if your income is low enough, and have restrictions on withdrawals before you reach 59 ½.
You can maintain both a Roth IRA and a Traditional IRA at the same time, and you can even convert Traditional IRA money to Roth IRA money if you’d like. Each year, you can contribute up to $5,500 across the two accounts.
Difference Between A Roth IRA vs Traditional IRA – Tax Benefits
The biggest difference between a Roth and a Traditional IRA is the type of tax benefit you get when you contribute.
With a Traditional IRA, you get to deduct any contributions you make from your taxable income. That means that you save money up front. Every dollar you put into a Traditional IRA reduces your take home pay by less than one dollar.
Imagine this scenario. Your taxable income for the year is $50,000. If you contribute $5,000 to your Traditional IRA, your taxable income drops to $45,000.
If your taxable income for the year is $50,000 your tax bill will total $8,238.35. If it’s $45,000, your tax bill will be $6,992.85. You’ll have saved $1,245.50 in taxes by saving $5,000 for your retirement. That means that each dollar you invested really only cost you 75 cents. You can’t beat an immediate return of 25% on your investment.
Because contributing to a Traditional IRA reduces your Adjusted Gross Income, you can use contributions to lower your income to qualify for some tax credits, including the Saver’s Credit.
When you reach retirement age, you can start taking money out of your Traditional IRA. That’s when you will have to pay tax on the money. Any money you withdraw from your Traditional IRA will be treated as regular income from a job for tax purposes.
That is why Traditional IRAs are called tax-deferred accounts. You’re putting off paying the tax until you plan to use the money.
Roth IRAs offer the exact reverse of the Traditional IRA’s tax benefit. When you contribute to a Roth IRA, you do not deduct your contributions from your taxable income. That means you have to pay the income tax now.
In exchange for the upfront payment of tax, you will not have to pay any taxes on your contributions, or the earnings, when you withdraw the money from your Roth IRA. When you take money out of your Roth IRA, you’ll know that every dollar will be going back into your pocket.
The other benefit of Roth IRAs is their flexibility. When you contribute money to a Traditional IRA, you lock it away until you turn 59 ½. If you want to withdraw the money before retirement age, you’ll have to pay the taxes owed and a 10% penalty on every dollar you withdraw.
With a Roth IRA, you can withdraw contributions, but not earnings, at any time. If you find yourself in dire financial need, you can withdraw money from your Roth IRA to cover the bills without paying tax penalties and making the situation even more damaging.
When Should I Use a Traditional IRA vs a Roth IRA?
Choosing whether to use a Traditional IRA or a Roth IRA can be difficult. It requires you to guess at how your current income will compare to your income in retirement, and how that will affect which tax bracket you fall into.
If you expect to have a higher income in retirement, your tax rate will be higher, so using a Roth IRA and paying the taxes upfront is the right choice. If you expect a lower income and therefore a lower tax rate, you should avoid paying a higher tax rate today by contributing to a Traditional IRA.
Traditional and Roth IRAs share some characteristics but their tax benefits could not be more different. Understanding the difference between the two is important if you want to make the best use of them.
Photo Credit: FranceGothic Images – Creative Commons Attribution License