Many people know they need to invest more for retirement. They just don’t know where to start outside of their company 401(K). For many people, an IRA is the best choice. So what is the difference between a traditional IRA and a Roth IRA?
Before I can effectively help you answer that question, there are a couple of basics to cover first.
WHAT EXACTLY IS AN IRA?
An IRA, or an Individual Retirement Account, is a way to help you save even more for retirement. It is an umbrella that will give your investments a lot of protection. Each year your investments will earn interest – read “free money for you.” AND the amount of interest earned compounds each year. This means that even a small amount invested can grow to a sizable chunk of money in a couple of decades.
WHAT IS ONE BENEFIT OF AN IRA?
One major benefit on an IRA is compound interest. Money sitting in an IRA earns interest, and each year that interest is compounded. What exactly does “compounded” mean? Let me give you an example.
Let’s say you decide to invest $5,000 into an IRA. In one year, assuming a 5% rate of return for easy math, you will make $250 in interest. The following year, that $5,000 investment grows to $5,250 and earns 5% of that new number, or $262.50 in interest. At the end of year two you will have $5,512.50 which will then earn $281.25. So at the end of three years, your initial $5,000 investment will grow to $5,793.75. Almost 800 bucks with no extra work from you. All because of compound interest that is added each year.
Now imagine what this will look like in ten years. Or twenty years. Even thirty years. Actually. Let me do the math for you. In ten years, you would have $8,144. And in twenty years you it would grow to $13,266. Thirty years? $21,609. All from a $5,000 investment. Made at one time.
And that’s just for one year of saving! Imagine if you did this every year. In your retirement years, this would all add up quickly.
WHAT IS ANOTHER BENEFIT OF AN IRA?
Another benefit of an IRA is the tax protection. We will talk a little more about what this looks like in a traditional IRA versus a Roth IRA farther down in the post. But for now, just know that both types of accounts grow without taxes eating into them. Now, taxes ARE paid. Either before you invest or when you pull the money out. But as long as it is sitting untouched, your money is growing tax free or tax deferred.
WHAT IS THE DIFFERENCE BETWEEN A TRADITIONAL IRA AND A ROTH IRA?
One of the major differences between a traditional and a Roth is how they are protected from taxes. A traditional IRA grows tax-deferred. This means that the taxes are deferred, or you pay them later. You can invest pre-tax dollars (usually straight out of your paycheck before they take out your taxes) into your IRA where it will go grow each year. When you go decades later to pull money for retirement, THEN will you pay taxes. The benefit to this is you have more money in the beginning to invest, which means more interest earned in the long run. The downside is you don’t know what taxes will look like in your retirement, so you don’t know how much will have to come out in taxes when you pull the money at retirement.
A Roth IRA is different. It grows tax-free. In a Roth IRA, you invest money that has already been taxed. So after you are paid and after the government takes their portion, you use your take-home dollars to invest in a Roth IRA. BUT this means that it has already been taxed. When you go to take money out for your retirement it will not be taxed again. This is great since you won’t need to worry about taxes rising any in the next couple decades. It won’t affect your investments since they’ve already been taxed. The downside is that it could potentially decrease the amount you can invest in the beginning if money is tight for you.
In both traditional and Roth IRAs, as of 2017, any individual who makes up to $118,000 can invest up to $5,500 each year. A married couple filing jointly who makes up to $186,000 can invest up to $11,000 each year. There are some limits to how much can be invested for those who make even more than $118,000 or $186,000 respectively. My guess is anyone reading this probably makes less than that. If you do, you probably have a financial planner due to other tax ramifications. So I’m not going to spend a bunch of time going over this.
Individuals who are age 50 or older can invest up to $6,500 each year. This is hopefully something that is taken advantage of so families can rack up even more savings before their golden years.
On another note, contributions to a traditional IRA can continue until the age of 70 1/2. Once you reach age 70 1/2 you can no longer contribute to a traditional IRA.
But there is no cut-off age for a Roth IRA. Contributions can be made indefinitely. As in forever.
You must start making withdrawals from your traditional IRA at the age of 70 ½. As soon as you turn 79 1/2, you will be penalized if you do not starting taking your money out.
A Roth IRA is much more lenient. There is no age requirement for withdrawals. This means that your earnings (that are growing tax-free!) can continue to grow and compound year after year. If you don’t need the money yet, it can continue to grow, tax free with no penalties.
With both the traditional and Roth IRA, early withdrawals (anything taken out before the age of 59 ½) will come with a hefty 10% penalty. AND anything that comes out of the traditional IRA will also be taxed as income for that year. Remember – the Roth IRA was already taxed as income before it was invested.
IF YOU DIE…
When you pass away, everything you have will be left to your loved ones. If you choose to invest in a traditional IRA, your beneficiaries might be liable to pay up to 40% of your savings (aka their inheritance) in taxes and fees.
However, if a Roth IRA is your investing vehicle of choice, your beneficiaries will get the IRA tax free. The Roth IRA can be handed over to beneficiaries without paying as much in taxes and fees.
WHICH ONE IS RIGHT FOR YOU?
Now that your head is swimming with information, how do you know which IRA account is the right pick for you? Every family is different. But there are a couple of things to consider.
Number one. Will you be in a higher tax bracket in retirement?
If so, a Roth IRA might be a better choice for you. You will pay less taxes now, so you should pay them and let your money to continue to grow tax-free, without any threat of rising taxes when you finally need to pull the money to use for retirement.
Are you in a higher tax bracket NOW than you will be in retirement? Then a traditional IRA might be the wisest choice. You can defer your taxes, have more money now to invest, and as you near retirement age (if you are in a lower tax bracket than you are now) you will pay less in taxes than you would have at the very beginning. You will probably pay less in taxes later if you wait.
**A quick note: This is not meant to be a hard and fast rule. It is simply a guide to think about based on the extensive research I have done. No one know what taxes will look like next year, much less in the next twenty or thirty years. I would definitely keep this in mind as you are planning for your future. You have to do what works best for YOUR family, and what best helps YOU sleep at night.
Number two. Think about how much money you have left over after tax to invest.
If it would be a struggle to invest enough from your take-home pay, it might be good to look into a traditional IRA. Investing pre-tax dollars will give you more money to start with, which means you will have more invested to compound even more interest.
If you have plenty of wiggle room in your budget to invest for retirement, I would highly encourage you to go for a Roth IRA. Any compound interest that grows will be tax free. You can begin withdrawing money whenever you want (after age 59 1/2) instead of being forced to take money out starting at age 70 1/2. AND your family will have much less stress and taxes if anything is left to them. Overall, it just sounds like a safer option offering more freedom in your choices.
I know it’s a lot to think about. But there some significant differences between traditional and Roth IRAs that can help you figure out which choice is a better fit for your family. No matter which one you choose, each dollar invested will help grow your retirement nest egg. The sooner you start to invest, the more free money you will earn in compound interest. Because who doesn’t love free money?
What about you? Have you invested in either a traditional or Roth IRA? How did you choose the one that was best for your family?
Interested in reading more about investing for beginners? You might want to check out these posts.