When you make the wise choice to start planning for retirement, you quickly find out there are many decisions to make about how your investments are set up. The world of retirement finance can be a dizzying place.
The two most widely-used individual retirement account types are the traditional IRA and the Roth IRA. We’ll take a look at some of the major differences between the two.
Keep in mind that while we’ll cover the basic differences between these IRA options, determining which account is right for you should include tailored advice from a professional with knowledge of your individual situation. Talk to a financial adviser for an individualized recommendation.
Traditional IRAs vs. Roth IRAs
Traditional IRAs (individual retirement accounts) have been around since 1974, and in 1997 the Roth IRA made its debut. Here are some things to keep in mind as you consider which is right for you.
1. Taxes on contributions and withdrawals.
This is the main characteristic that separates traditional IRAs from Roth IRAs.
Traditional IRAs are taxed later. When you contribute to a traditional IRA, that contribution isn’t taxed yet. Instead, it goes straight into your IRA to start earning interest. This means with a traditional IRA, your contributions reduce your taxable income for the year in which you’re contributing.
So when do the taxes hit?
Eventually, you will retire and begin to make withdrawals from your traditional IRA. These withdrawals count as taxable income. With a traditional IRA, you pay taxes as you withdraw.
Roth IRAs are taxed now. But with a Roth IRA, the taxation model is reversed. Contributions to your Roth IRA are still considered taxable income, so you pay income tax on the money you’re stocking away for retirement.
That means Roth IRAs don’t do much for you in the way of reducing taxes now. However, Roth IRA withdrawals are tax-free. You can see how this makes Roth IRAs attractive to hopeful retirees: Many people would rather pay income tax at the current rate than risk a higher income tax rate in the future.
2. Taxes on gains.
Now we know how contributions and withdrawals are taxed, but what about the gains your IRA makes over the years? Depending on your IRA type, these are taxed differently too.
Traditional IRA gains are taxed. Because traditional IRA withdrawals are taxable income, you’re not just paying taxes on the money you put in. The gains are taxable, too.
For example, let’s say you contribute $100,000 to a traditional IRA, and it grows to a size of $200,000 by the time you retire. Every withdrawal you make is taxable income. This means you’re not just paying taxes on the original $100,000 you invested. If you withdraw everything from the account over your time in retirement, you’re paying taxes on all the wealth you’ve grown through investments too.
Roth IRA gains are tax-free. However, Roth IRA contributions have already been taxed up front. This means your Roth IRA can grow tax-free for life.
3. Access to your contributions.
Depending on your IRA solution, you can take back your IRA contributions at different times (which may or may not be penalized).
Traditional IRA contributions are more restricted. Generally speaking, if you set up a traditional IRA, you cannot access that account until you reach the age of 59 ½. For most people, early withdrawals incurs large penalties—on top of the income tax.
Roth IRA contributions can be accessed at any time. Because Roth IRA contributions have already been taxed, investors can take back Roth IRA contributions at any time without the steep penalties that come with a traditional IRA. However, this goes for contributions only—not gains.
4. Distribution requirements.
Traditional and Roth IRAs have various rules surrounding distributions—when you begin withdrawing from your IRA.
Traditional IRAs must begin distribution at age 70 ½. During the year you turn 70 ½, you must begin taking a minimum required distribution from your traditional IRA.
Roth IRAs don’t have this rule. You are not required to withdraw from your Roth IRA at any time, which means your investments can continue to grow tax-free no matter how old you live to be.
Retirement requires planning.
An IRA is only one piece of the Christian’s retirement plan. Talk to your financial adviser about which IRA type is best for you and what other financial tools might be a good fit.
Curious about planning your retirement in a way that benefits the Kingdom? See how CDF IRAs help churches grow!
