Deciding to invest your money in a traditional vs Roth Individual Retirement Account (IRA) can be confusing. For starters, there are several differences between these two types of IRAs.
This guide will help you to get a better understanding of the differences between these two IRA accounts.
What Is a Traditional IRA?
A traditional IRA allows individuals to direct pre-tax income into investments that can be tax-deferred. This means that any dividend income or capital gains taxes will grow inside the IRA until a withdrawal is made.
Depending on the taxpayer's tax filing status and income, the contributions made to a traditional IRA may be tax-deductible.
What Is a Roth IRA?
While Roth IRAs are similar to traditional IRAs, the biggest difference between these two accounts is how they are taxed.
Because Roth IRAs are funded with post-tax funds (money that has already been taxed), the contributions made toward the Roth IRA aren't tax-deductible.
However, you can withdraw money from your Roth IRA account, including any earned dividends and interest, without having to worry about paying taxes once you reach the age of 59 and a half.
What Are the IRA Differences Between Traditional Vs Roth?
With a Roth IRA, you can open up an account and begin contributing at any age. However, some companies won't allow you to contribute if you're over the age of 70 and a half years for a traditional IRA.
In addition, your income will affect how much you're able to contribute with a Roth IRA, which we’ll cover next. With a traditional IRA, as long as you're over the age of 18 and have earned some type of income, you can contribute, but may not be tax-deductible depending on how much you made that tax year.
Another difference between a traditional IRA and a Roth IRA is that you can withdraw your contributions (but not your earned interest) without worrying about taxes or penalties from a Roth IRA. With a traditional IRA, you'll have to pay taxes and penalties when you draw any finances out prematurely.
What Are the Income Restrictions for IRA Accounts?
The IRS has stated that contributions for both a Roth IRA and a traditional IRA combined can't be more than $6,000 in 2020 if you're under the age of 50.
However, if you're over the age of 50, that total contribution can go up to $7,000. In addition, if your total compensation was less than these dollar amounts, your total contribution can't be more than the total amount for the entire year. For example, if you earned $5,000 in income during the year, you can’t contribute the $6,000 maximum to an IRA account.
Keep in mind that your Roth IRA contribution limit may be decided by your filing status and your current income. Here’s the official Roth IRA contribution limit chart from the IRS website:
A spousal IRA can also be set up for a non-working spouse by the working spouse even if the non-working spouse didn’t have any earned income that tax year.
How Do You Choose the Right Type of IRA Account?
Deciding whether you should invest in a traditional IRA or a Roth IRA can seem tricky. Knowing that the biggest difference between a traditional IRA and a Roth IRA is the tax advantages you can expect may help make your decision easier. To decide whether you should open a traditional or Roth IRA, ask yourself one question. Would you rather pay taxes on the retirement account now or in the future?
If you would rather pay your taxes upfront and be done, a Roth IRA is better for you. Or if you’d rather defer them until you’re retired, choose a traditional IRA instead.
That said, everyone’s tax situation is different. If you have questions about which is best for you, consult a CPA or tax professional.
What Is Your IRA Eligibility?
You may not have the ability to choose between a regular or Roth IRA. The IRS regulations may dictate which IRA you’re eligible for.
How much income you receive will determine if you're eligible to contribute to a Roth IRA. In addition, the IRS will also determine how much of your contribution to a traditional IRA you will be able to deduct from the current year's taxes.
Understanding Whether a Traditional Vs Roth IRA Is the Right Choice for You
A traditional IRA can provide you with a tax break if you're eligible. However, if you're not concerned with having upfront tax benefits from your IRA account, a wise investment would be the Roth IRA.
Understanding the differences between a traditional vs Roth IRA will help you to make the best financial decision for your future.