There are two primary types of IRAs, the Roth IRA and the Traditional IRA. With a traditional IRA, the funds that are invested are potentially tax deductible to the account owner, similar in nature to a 401(k) through an employer. The money taken out of a Traditional IRA at retirement is taxed at the account owner’s individual or joint tax rate.
On the flip side, the money invested into a Roth IRA is not tax-deductible. The funds placed in a Roth IRA are however withdrawn tax free in retirement, including the account’s gains, providing a huge incentive for investors who are looking to reduce their taxable income in retirement. So, to summarize, Traditional IRA’s are taxed on the backend, while Roth IRA’s are taxed on the front end.
Roth IRA Contribution Limits
Now that you have the basics down with regards to the Roth IRA, it is important to also become familiar with the differences between the Roth IRA and the Traditional IRA. Each investment account type offers the investor advantages and disadvantages that must be taken into consideration when selecting the best one to utilize. Both the Traditional IRA and the Roth IRA have annual contribution limitations as well as catch up provisions for investors who are over the age of 50. It is advised to discuss these with your tax advisor or to visit the IRS website prior to making an investment.
The contributions to a Roth IRA account are never tax deductible, while in some cases depending on the income of the person who is contributing, they are deductible for the Traditional IRA.
There are annual income restrictions for contributions made to the Roth IRA. There are not income restrictions for contributions to a Traditional IRA, but there are restrictions for the amount if any of the contributions made that are tax deductible.
The earnings of both accounts grow tax deferred until the funds are withdrawn. When funds are taken out of a Roth IRA after the age of 59 ½, they are in most cases free of state or federal income taxation. Traditional IRA funds withdrawn after the age of 59 ½ are taxed at the account owner’s ordinary income tax rate.
Required Minimum Distribution Rule
This rule does not apply to Roth IRA accounts, but the beneficiary of these accounts are subject to this rule. The funds within a Traditional IRA are subject to this rule, requiring the account owner to take withdrawals after the age of 70 ½.
Why Choose Roth IRA over Traditional IRA
The graphic above shows why opening a Roth IRA account will save you more money for retirement than the Traditional IRA. In the example above, the calculator set to the following parameters:
- Age: 35
- Rate of Return: 8%
- Annual Contributions: $4,000 per year
- Tax rate: 30%
- Retirement age: 66
- Annual Gross Income: $80,000
- Retirement Tax Rate: 25%
At the age of 66, you would have either:
- $688,000 if you invested with a Roth IRA account or
- $558,000 if you invested with a Traditional IRA account
The key difference is the tax savings. Since all Roth IRA contributions are pre-taxed, you save all those tax dollars in the future when you withdraw those funds. On the other hand, the Traditional IRA account is extremely tax-inefficient, and will cost you hundreds of thousands of dollars due to its after-tax qualities. For most families, Roth IRA accounts are the best way to save for retirement.
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