There are an incredible amount of investment vehicles to consider when thinking about your future. So many that it can be overwhelming sifting through the options and weighing which route you should take. Let’s compare two that are often confused with each other and decide which one is best for us. They are the Traditional and Roth IRA’s.
Before we dig in, what is an IRA?
IRA stands for Independent Retirement Account. They are used to help you invest your money now to increase in value for the time you retire.
I know, if you’re young, who cares about retiring? But let me ask you, if the point of working isn’t to retire, what’s the point? Sure, you want to enjoy your life now, but if you focus on your retirement now when you’re young, you’ll be able to retire much younger than your peers.
While Traditional and Roth IRA’s both help you save for retirement, there are some fundamental differences between the two that you will want to consider when opening up an account.
Before we get into the differences, let’s talk about the similarities.
Similarities Between Traditional and Roth IRA’s
Both the Traditional and Roth IRA’s have a contribution limit of $6,000 per year for 2019 and 2020. If you are over the age of 50, you will be able to contribute an extra $1,000 per year.
Generally, the deadline to contribute for a tax year is the following year’s tax deadline. That means in January-April 15, 2021, you’ll be able to contribute to your 2020 $6,000 limit without contributing to your 2021 limit.
Why would you do this? We’ll get into that later. Depending on the account you have, there are some additional tax incentives. However, taking the tax incentive out, it allows you to contribute more money in 2021, it’s a win-win.
Keep in mind, the tax deadline is generally April 15th for individual filers. However, due to COVID-19, the individual tax deadline is now July 15th, so you can still make contributions to your 2019 limit!
Now let’s talk differences.
Differences Between Traditional and Roth IRA’s
The main fundamental difference between a Traditional and Roth IRA’s relates to taxation.
A Roth IRA is contributed to using your post-tax money. This means you are getting money from your W-2, which is already taxed, then contributing to your Roth IRA.
What does this do for you?
Your money in the Roth then grows tax free and upon retirement, you can withdraw your money completely tax free. This is because it was already taxed when you contributed it.
A Traditional IRA works the opposite. You contribute pre-tax dollars. These accumulate tax free as well, but you are taxed upon withdrawal in retirement. This is because you were never taxed on your contribution like you were with the Roth IRA.
This might seem like the less appealing option, but there is one added benefit to contributing to a Traditional IRA.
You get a tax deduction in the year you contribute.
The max deduction you can receive is $6,000, but it is phased out if you make over a certain amount of income. You can read about those limits here.
The big question when thinking about IRA’s when it comes to taxes is when do you want the tax benefit? Now or later?
If you don’t want to pay taxes later when you are retired, choose the Roth. If you want the tax deduction now, use the Traditional.
The Roth IRA has no age requirements. You can contribute at any age.
A Traditional IRA does not allow contributions if you are over 70 ½. For 2020, due to COVID-19, you are allowed to contribute at any age.
Now, I imagine most of the viewers here are not over 70 ½ years old. But notice how I said no age requirements. You don’t need to be 18 or 21 for IRA’s. If you are 16 and want to start thinking about saving, do it! The earlier you start the better.
With a Traditional IRA there are no income requirements. For a Roth IRA, things are a little different. You can find those contribution limits here.
Early Withdrawal Penalties
Notice how these are Individual Retirement Plans. Meaning they are meant for retirement. Because of this, there are penalties for early withdrawal.
For both the Traditional and Roth IRA’s, you may have to pay a 10% penalty on withdrawals before the age of 59 ½.
I say “may have to” because there are some exceptions.
For Roth IRA’s, withdrawals are tax free if the money has been invested for at least 5 years, and you satisfy one of the following:
- First time home buyer
- Age 59 ½
- Death (let’s hope it’s not this one)
For Traditional IRA’s, withdrawals are tax free if you qualify for one of the following:
- Qualified higher education expenses
- Qualified first time home buyer ($10,000 limit)
- Certain major medical expenses
- Certain long term unemployment expenses
Other than these cases, you will be taxed if you withdraw before 59 ½.
Required Minimum Distributions
There are no required distributions for Roth IRA’s. Let that money grow!!
For Traditional IRA’s, you must start withdrawing at the age of 72.
Again, this isn’t relevant to most, but I wanted to give all of the facts.
How Do I Open Up An Account?
I personally use Vanguard for my Roth IRA, they offer a ton of great funds with low fees to buy into and have a great interface for investing long term. I don’t receive any benefit if you open an account through Vanguard, I just truly believe that they have the best option for IRA’s.
Both the Traditional and Roth IRA’s have pros and cons. As I mentioned earlier in the post, it boils down to your tax preferences. Do you want to get the tax deduction now with the Traditional IRA or the tax free withdrawals in retirement with the Roth IRA?
Either way, I highly recommend that you get started with investing today. The earlier you start, the more your money accumulates over the long term.
Do something great for yourself and invest in your future self today.