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An Individual Retirement Account – IRA as it’s commonly referred to – is one of the most widely- used investment tools in America. You’ve likely heard the terms, “Roth,” and, “Traditional,” used to refer to IRAs as well – but what’s the difference?
A traditional IRA is used mainly for people who expect to be in a lower income tax bracket when retirement comes around. It’s also usually a better option for those who haven’t started an IRA until their mid-40s or later. Bear in mind, though, that you can’t use a traditional IRA past the age of 70 ½.
Contributions made to a traditional IRA go in before taxes are paid on that income, and you can almost always write those contributions off to get a bit of a tax break. However, when you begin to withdraw money from your traditional IRA, you’ll pay taxes since those withdrawals are counted as regular income.
A Roth IRA is quickly becoming the most popular option. Contributions go in after taxes – meaning you can’t write that money off for a tax break at any point in time – but since that money has already been taxed you won’t pay any taxes upon withdrawal.
Both the Roth and traditional IRA do charge a 10% penalty (as per IRS regulations) if you withdraw money before age 59 ½, though the traditional charges that on withdrawals of contributions and the earnings of your IRA. A Roth charges just on withdrawals of earnings.
Which should I use?
Your individual needs will have to be considered when making the choice for an IRA, but a great way to start is to use a Roth vs traditional IRA calculator. This will allow you to input your desired contributions along with your current and projected tax brackets. With a little bit of other possible information, you’ll see a projection of your income via both accounts to show which way to go.
To give you a more tangible example of what the differences between a Roth and traditional IRA are, let’s run some numbers through the calculator.
Let’s say you’re 29, make $75,000 per year, and contribute the full amount of $5,500 per year to your IRA. Before we go too much further, note that the U.S. Census Bureau calculated average household income in the U.S. at $73,298, the last year for which the data is available. A round number like $75,000 is easier to deal with for this hypothetical situation.
Now, back to the math – if you’re 29, making the average household income, and contribute as much as legally possible to your IRA, that amounts to $198,000 contributed between age 29 and 65 (target retirement age).
With a traditional IRA, you’d have $891,262 to use as retirement income. Since it is a traditional IRA, you’ll have to pay income taxes on the money you withdraw each month.
If you lived to 85, that’s roughly $44,563 per year. This would put you in the 25% tax bracket if you’re single, or the 15% bracket if you’re married.
With a Roth IRA, however, your savings between 29 – 65 would be $876,356. That’s $43,818 per year for 20 years of retirement. Although the key here is you don’t have to pay taxes on any of this money. Since it’s already been taxed, you don’t have to pay taxes again.
Running the numbers gives you a sense of clarity before heading into a meeting with your financial adviser. This makes the entire world of investments and retirement savings a bit more palatable.
Knowing the difference between a traditional and Roth IRA can mean the difference between a comfortable retirement and one in which you’re just scraping by. While the differences may not appear overtly significant, your age, potential income, and taxes all play a major factor in which type of IRA you should choose. Knowing the differences gives you the power to make that decision.