Roth IRA vs. Traditional IRA

An IRA is a type of savings account for retirement, and there are two main types: Roth and traditional. Both help you save money for your future, but they work differently, especially when it comes to taxes.

The difference between Roth and traditional IRAs

The main difference between a Roth IRA and a traditional IRA is when you get a tax break. With a traditional IRA, you don’t pay taxes on the money you put in, but you do pay taxes when you take it out in retirement. With a Roth IRA, you pay taxes when you put the money in, but you don’t pay taxes when you take it out in retirement. This means Roth IRAs can grow tax-free over time.

You can have both types of IRAs if you want, but choosing which to contribute to depends on your situation and what you want out of the account.

Quick comparison: Roth vs. traditional IRA

How to choose between a Roth or traditional IRA

Most people ask themselves: Will my tax rate be higher or lower when I retire? If you think it will be higher, a Roth IRA might be better since withdrawals are tax-free. If you think it will be lower, a traditional IRA could be the right choice because you get a tax break now.

But it’s really hard to know what your tax rate will be in the future, especially if retirement is far away. Fortunately, there are other things to help you decide. For many people, the choice might come down to how much money you make, as the IRS has rules about who can contribute to each type.

You can contribute to both a traditional and a Roth IRA in the same year, as long as the total does not exceed the maximum amount allowed.

Why the Roth IRA works for many savers

If you aren’t sure, many experts suggest either using both or going with a Roth IRA, especially if retirement is far off. Here are some reasons why a Roth IRA might be better:

1. Early withdrawal rules are more flexible with a Roth. While it’s usually not a good idea to take money out early, you can take out the money you put into a Roth IRA anytime without a penalty. If you take out the earnings early, you might have to pay taxes and a penalty. Traditional IRAs are stricter: taking out money early means you pay taxes and a 10% penalty unless you meet specific exceptions.
2. No required minimum withdrawals with Roth IRAs. With traditional IRAs, you have to start taking out money when you reach a certain age (currently 73, and will be 75 in 2033). With a Roth IRA, you don’t have to take money out if you don’t want to, so your savings can keep growing.
3. More after-tax savings in a Roth. The tax benefits of a Roth IRA come in retirement, which means you won’t be tempted to spend any tax savings you get now. This can help you save more for the long term. With a traditional IRA, the tax break is immediate, and you might be tempted to spend that money rather than invest it back into savings.
4. Tax diversification with a Roth and a 401(k). Most employer retirement plans, like 401(k)s, are similar to traditional IRAs in terms of tax benefits. If your employer doesn’t offer a Roth 401(k), putting some of your savings in a Roth IRA can help balance your tax situation in retirement.
5. Roth IRAs can be useful for estate planning. If you don’t use all the money in your Roth IRA, your beneficiaries can inherit it tax-free, which makes it a good choice for passing on savings.

The main advantage of a traditional IRA is the tax break you get now. This can be helpful if you’re a high earner or need extra motivation to save. But eventually, you’ll have to pay taxes on that money in retirement. For most people, unless you really need the tax break right now, a Roth IRA can be a smart choice because of the tax-free growth.

Key Financial Terms

1. IRA (Individual Retirement Account): A type of savings account designed to help you save for retirement with tax benefits.
2. Roth IRA: A retirement account where contributions are made after taxes, and withdrawals in retirement are tax-free.
3. Traditional IRA: A retirement account where contributions may be tax-deductible, but withdrawals in retirement are taxed.
4. Tax-Deductible: An expense that can be subtracted from your income before calculating taxes, which reduces your taxable income.
5. Required Minimum Distribution (RMD): The minimum amount you must withdraw from certain retirement accounts each year once you reach a specific age.
6. Penalty: An extra charge by the IRS, usually for taking money out of a retirement account before a certain age.
7. Tax-Free Growth: When money in an investment grows and you don’t have to pay taxes on that growth.
8. Beneficiaries: People who receive money or assets when someone passes away.