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Good morning, good morning! Or afternoon or night or whenever you’re reading this…. This blog post dives into the key similarities and differences when it comes to IRAs.
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Table of Contents
What is an IRA
First and foremost, what is an IRA? IRA stands for Individual Retirement Account. This is an account that anyone with earned income can open, regardless of age, to save for retirement. Most big banks and brokerages offer this account so it is easily accessible and not dependent on an employer.
IRAs offer incredible tax benefits! Because of this you are only allowed to contribute $6,000 annually or $7,000 if older than 59½.
The timing of the tax benefit is what predominantly differentiates the two types of IRA accounts. These two types of IRAs are: the Roth IRA or the Traditional IRA.
“Roth” Definition
Let’s first get into the biggest difference between these two accounts. Well, one is “roth” while the other is traditional.
Roth means your contributions are AFTER tax. Income tax was paid, the money was contributed, then, during retirement, you won’t have to pay taxes on ANY of that money.
On the other hand traditional IRA contributions are before tax. This is awesome because that money then becomes a tax deduction, making your income taxes go down! However, when you use that money in retirement, you have to pay the taxes.
TLDR
Roth / after-tax = pay taxes now, money grows and you pay zero later
Traditional / pre-tax = current taxes decrease, money grows tax free, then you pay taxes in retirement.
With both accounts you get a tax benefit, but the key difference is the timing of that tax benefit.
Income “Limits”
Although both of these accounts are easily accessible there are income limits to the Roth IRA.
In order to be eligible to make contributions into a Roth, your income must be less than $144,000 a year. HOWEVER, there are ways to get around this called the Backdoor Roth.
So even though a key difference between these accounts is that one has an income limit while the other does not, this difference doesn’t even really count! You can get around it pretty simply.
Withdrawals and Distributions
Both accounts have rules surrounding withdrawals and distributions before the age of 59½. 59½ is the age when you will no longer have restrictions when it comes to withdrawals.
This is the age you can start withdrawing your Roth and paying no taxes on that money! However, withdrawing prior to that age may trigger some taxes and penalties.
Withdrawing Contributions
First and foremost, before we get into the rules for taking out money before age 59½ let’s talk about your contributions.
With a Roth IRA you will always be able to withdraw your contributions tax and penalty free at any time. Contributions means any money you put into the account which is different from your earnings which would have a tax and/or penalty if withdrawn before age 59½ .
That is not the case with a Traditional IRA. Because Traditional IRAs are before taxes, when withdrawing, that money would be taxed as ordinary income regardless of if it was a contribution or earning.
Roth Distribution Requirements
As mentioned previously, contributions can be withdrawn at any age and at any time, so here we are talking about withdrawing EARNINGS. To be able to benefit from paying no taxes on your Roth account earnings you must be over age 59½ AND have held your Roth account for at least 5 years.
If you withdraw after age 59½ but before the 5 year mark, you will be subject to taxes and penalties. If you withdraw after the 5 year mark but before age 59½, you will be subject to taxes and penalties.
The only other way to withdraw before age 59½ and/or before your account is 5 years old is with one of the following exceptions:
- You are using the money to pay for your first home (up to $10,000)
- Use the withdrawal to pay for qualifying education expenses, birth or adoption expenses, health insurance when unemployed or unreimbursed medical expenses
- You become disabled or pass away.
Traditional Distribution Requirements
Similar to the Roth IRA 59½ is a significant age for this account. You will be charged a 10% fee if you withdraw any contributions and/or earnings from your Traditional IRA account before the age of 59½. Unlike the Roth even your contributions will be subject to penalties when withdrawn early.
However, you have the same exceptions as with the Roth that will bypass these penalties..
- You are using the money to pay for your first home (up to $10,000)
- Use the withdrawal to pay for qualifying education expenses, birth or adoption expenses, health insurance when unemployed or unreimbursed medical expenses
- You become disabled or pass away
Furthermore, Traditional IRAs have something called a Required Minimum Distribution (RMD). When you turn 72, you must start withdrawing from your Traditional IRA account. If you do not make your RMD you will have to pay a 50% penalty on the amount you should have withdrawn.
This is basically a way for the government to guarantee you’re paying taxes on the money in your account, since you were able to defer taxes when initially contributing.
The amount you need to withdraw for your RMD is calculated by dividing the value of your account by your life expectancy, the IRS has more specific rules on how they determine your life expectancy.
Traditional vs Roth IRA Summary
Both: Easily accessible accounts you can open at most banks and brokerages designed for you to save for retirement. Can only contribute $6,000 annually or $7,000 if older than 59½.
Roth: Pay taxes now, don’t pay any later! Must earn less than $144k a year (but there are ways around this). You can withdraw your original contributions at any time. To get all the benefits you must wait until you’ve had the account for 5 years and are older than 59½. No RMDs!
Traditional: Get a tax deduction now, pay taxes later! No income limits. Must be 59½ to not pay a penalty when withdrawing ALL money. Required to take distributions at the age of 72.
Which IRA Account Should You Open?
The general rule for deciding which IRA account you should open is, if you are in a lower tax bracket you should contribute to a Roth, then as you move into higher tax brackets switch over to a Traditional. I DON’T PERSONALLY AGREE. However, the theory behind this is that if you’re going to pay taxes on this money now, it might as well be while you’re in a lower tax bracket.
However, like I said, I don’t agree with this.
I personally think (not financial advice, just my opinion) that everyone should be taking advantage of a Roth IRA and get pre-tax exposure through a 401k instead.
Because you are only allowed to contribute $6,000 annually into an IRA I think it is more beneficial to get Roth benefits. Although there are income limits to the Roth IRA, as previously mentioned, there are ways around those. You want to have a pile of money growing that you know you will never have to pay any taxes on.
Final Thoughts
Regardless of which IRA account you want to open, we should be taking full advantage of any account that can provide us with a tax benefit!!!
Tax advantage accounts are a game changer and make saving for retirement slightly better.
Which account did you decide to open?
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