When opening an IRA, you must decide between a traditional account and a Roth account. Here are some of the advantages of each kind and things to consider when making your decision.
For many independent pastors and employees of small businesses, an individual retirement account, or IRA, is their only tax-advantaged retirement savings option. Even if your employer offers a 401(k) or 403(b), it might be a good idea for you to open your own IRA so that you have more control over your investment options.
For most people, whether or not to open one is an easy decision. The hard part is deciding which kind to have, a traditional or a Roth. Here are some of the benefits of each and their differences, to help you decide which kind is right for you.
Advantages Of A Traditional IRA
Prior to 1997, there was only one kind of IRA, now known as a traditional IRA. It is a tax-deferred retirement account, meaning it is funded with pre-tax money. You don’t pay any taxes until you withdraw the money in retirement. The benefit of this is that you have more money available to invest if you don’t have to take taxes out of it first. Also, you may find yourself in a lower tax bracket in retirement. That would allow you to pay less in taxes than you would have if you paid the taxes up front.
Advantages Of A Roth IRA
In 1997 a new kind of IRA was born. It was named after Senator William Roth, who sponsored the act that created them. Roth IRAs differ from traditional ones in a few key ways.
The biggest difference between the two is the tax treatment. Whereas traditional IRAs are tax-deferred, with a Roth you pay all taxes up front. In exchange, you don’t have to pay taxes on any of the growth. Everything generated by compounding interest stays in your pocket.
Also, traditional IRAs have required minimum distributions and Roths do not. So, if you don’t need all of your money to live on in retirement, you can leave your money in the account to grow forever. With a traditional account, you have to start taking withdrawals and stop contributions at age 70 ½. If you have excess savings you can use this aspect of Roth IRAs as a way to provide tax-free income for your heirs.
You can withdraw money penalty-free before age 59 ½ for qualified first-time home purchases or education expenses with both kinds of accounts. With Roths, you can also withdraw contributions (not growth) at any time for any reason without penalty.
There are limitations on who is allowed to use a Roth IRA based on income. That won’t be a problem for you, though, if you earn less than $118,000 as a single or $186,000 for a married couple.
Which Type Of Account Is Better For You?
Because of the way the taxes are handled, a Roth IRA is almost always better for younger people. They have more time to save and let their money grow, which is tax-free. If you are nearing retirement and your money won’t have a lot of time to accumulate interest, you may be better off with a traditional IRA.
Many people choose a Roth regardless of their age so that they won’t be required to take distributions and can leave more of the money to their families. This only applies if you won’t need all the money to live on in retirement.
If you are rolling over an old 401(k) to open your IRA, you need to consider the tax implications. You won’t have to pay any taxes to roll a traditional 401(k) into a traditional IRA. To roll it into a Roth, though, you will have to pay taxes on the entire account. If you can’t afford to pay the taxes right away, you can roll some of it into a traditional account and convert it later on when you can afford the taxes.
The best kind of IRA for you depends on your age and goals. Above are the things that you should take into consideration when making your decision. Don’t get hung up on it, though. No matter which you choose, you are saving for retirement. In a country where 1 in 3 people has no retirement savings whatsoever, that makes you a winner! Good job, I’m proud of you!