It’s never too late to start saving for retirement. Discover the differences between a traditional and Roth IRA, then choose the one that’s the most beneficial.
If there’s one thing every person should know about, it’s the importance of starting a retirement account. Although there are many possibilities, there isn’t a “one-size-fits-all” solution. That means you need to select what’s going to be the most beneficial to you and your unique situation.
For instance, if you work for a company that doesn’t offer any type of retirement savings, you might consider an Individual Retirement Account, otherwise known as an IRA. If you opt to take that route, you’ll need to decide between a traditional IRA and Roth IRA. As with any savings, it’s essential to factor in all the variances to ensure you make the right decision.
Understanding the Basics of IRAs
When it comes to investing in either a traditional or Roth IRA, the process works much the same. You open an account, put money in it, and then continue adding more if wanted. While exchange-traded funds and mutual funds are the most popular choices, you also have the option of investing in securities, including stocks and bonds.
Regardless, the goal is to make decisions that’ll help your money grow, thanks to compound interest.
The primary difference between a traditional and Roth IRA is taxes. If you go with a traditional IRA, the money you invest is tax-deductible. Therefore, every dollar contributed helps lower the amount of taxable income. Of course, the reduction must line up with what the Internal Revenue Service (IRS) allows. In 2020, the IRS limit is $6,000.
With a traditional IRA, your money grows but without any taxes applied. It’s only after you begin taking distributions that the government would tax the money. At that point, the amount of tax paid would be the same as if the money were standard income. In some states, money in a traditional IRA is tax-exempt, meaning you wouldn’t pay any state taxes.
At the age of 70.5, you’d need to take Required Minimum Distributions, or RMDs. As such, your ability to contribute to the account would end. Simply put, with a Traditional IRA, you don’t have the option of growing your money indefinitely.
Now let’s look at how taxes work with a Roth IRA. For this, you fund the account using after-tax money. For that reason, you can’t deduct any of the contributions made. Since you pay taxes on the money when putting it into the account, you’re not taxed when taking it out. Not only does that apply after you retire but before retirement as well.
Another difference, with a Roth IRA, there are no RMDs. Therefore, you can take money out as and when needed as opposed to waiting until you’re 70.5 years of age. Something else worth noting is that with a Roth IRA, as long as you’re working, you can contribute funds. With so many people still employed into their 70s and even 80s, that’s a nice benefit.
Choosing the Right IRA
As someone who takes retirement seriously, it’s essential to make the right choice between a traditional and Roth IRA. First, understand fully how the taxes work for each. If you’re currently in a somewhat higher tax bracket but believe you’ll drop to a lower one after retiring, it makes perfect sense to open a traditional IRA. However, if the opposite is true, then you should go with a Roth IRA.
There are free calculators that can help you figure out if a Roth IRA makes sense for you, but most of them are pretty inaccurate. You can also use a more sophisticated (not free) planning tool called WealthTrace, which allows you to run more complex what-if scenarios including Roth IRA conversions.
You also want to factor in a 401(k). If you have one through your employer, you’re already enjoying several benefits offered by a traditional IRA. For instance, the contributions you make reduce the amount of your taxable income. As your money grows, it’s tax-deferred.
The contribution limits set by the IRS are higher for a 401K than they are for both a traditional and Roth IRA. Therefore, if you’re putting money into a 401K, opening a Roth account as well can prove beneficial. That way, you can diversify your retirement holdings. Simply put, when you retire, one source of income isn’t taxed.
Without RMDs, a Roth IRA is beneficial to a lot of people. If you have other sources of income to support you in your retirement years, you won’t have to dip into your savings. There’s one other appeal about a Roth IRA. Unlike a traditional IRA, you can leave the money in a Roth account in your will for distribution to heirs.
If you have taxable accounts with gains or income, you can use that money to fund a Roth IRA. As far as the income limit, it’s $137,000 for singles and $203,000 for married couples who file taxes together. Also, for this type of IRA, there’s a conversion known as a “backdoor.” For that, you would put money into a non-deductible traditional IRA, followed by rolling it over to a Roth.
If you choose the “backdoor” conversion, any money you roll over is taxable. While this is currently an option, it may not always be available. Some tax reformists believe it’s a legal loophole that the government should close. Doing so would prevent extremely wealthy Americans from gaining access to it.
It’s sad, but roughly 50 percent of Americans don’t have any type of retirement savings account. If you’re in a position to choose between a traditional and Roth IRA, count yourself fortunate. Before making a selection, be sure to carefully review any implications of estate planning and taxes.
You want to pay attention to the fees charged for both types of IRAs. The goal is to choose an account with low fees so they don’t eat away at the value of your holdings. Regardless of your age, it’s never too late to act. Therefore, talk to a professional financial planner as soon as you can. An expert can answer more questions and guide you to the IRA that’ll serve you best.