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Traditional and Roth IRAs: Simple Guide and What to Know

Currently, 50 percent of households are at risk of not having enough money to keep their lifestyle when they retire, so knowing the difference between Traditional and Roth IRAs matters. The tax-advantaged accounts are essential parts of retirement planning.

Investing for retirement is necessary no matter what age you are today. If you’re in your 20 and 30s, thinking about retirement might be something that rarely crosses your mind. You’re young, so why should you think about old age? 

Well, taking retirement planning early by having an IRA is an intelligent move that you’ll be thanking yourself for when you retire.

Before you open an IRA account, you will need to choose between the two types: a traditional IRA or a Roth IRA. In this article, you will learn what Traditional and Roth IRAs are and how to choose the best one for your retirement.

What are Traditional and Roth IRAs?

IRA stands for Individual Retirement Arrangement. It’s an IRS-specific arrangement offering multiple accounts to invest a portion of your income so you can use it when you retire. You should open an IRA account because you will have some pretty sweet tax advantages, the kind that you won’t get with a regular savings account.

What is a Traditional IRA?

The traditional IRA contributions are made on a pre-tax basis, often lowering your taxable income. Your investments in a traditional IRA can grow tax-deferred until you begin making withdrawals. You will have to pay income taxes when you withdraw money from the traditional IRA once you retire. An IRA can be opened by an individual regardless of employment. It’s the best option for self-employed and independent contractors.

The traditional IRA contribution limit for 2021 is $6,000 if you’re younger than 50. Suppose you’re 50 or older, then the limit is $7,000. 

What is a Roth IRA?

If you choose a Roth IRA, your contributions will not be tax-deductible, but it will allow you to invest your money after taxes, up to a certain amount each year. The earnings and withdrawals from the Roth IRA are tax-free after age 59½.

The Roth IRA contribution limit for 2021 is $6,000 if you’re younger than 50. Suppose you’re 50 or older, then the limit is $7,000. 

How to Choose Your IRA: Pros and Cons

One of the key differences is how the tax breaks are different: with a traditional IRA, the money contributed isn’t taxed; with a Roth IRA, the money you take out, once you’ve reached retirement age, isn’t taxed. Roth IRAs also have no timeline requirements to withdraw money.

The best way to know how to choose your IRA is to see the differences between a traditional IRA and a Roth IRA, which we’ll detail below.

Employer plan. Depending on your employment status, your eligibility to contribute to an IRA and take a tax deduction depends on your participation in a retirement plan offered at work like a 401(k).

Tax bracket. You should think about how your tax rate will be in the future: will it be higher or lower? A Roth IRA will be better for you if the tax bracket in retirement is higher because you get the delayed tax benefits. A traditional IRA is best for people with a lower tax rate in retirement because of deferred taxes.

Eligibility. Besides the contribution limit we talked about, you should also know that the Roth IRA comes with an income limit, meaning that depending on your income, you might be eligible for a Roth IRA or not. The income limit of a Roth IRA for 2021 is $140,000 if you’re a single filer and $208,000 for joint filers (together with your spouse).

Now let’s take a look at the pros and cons when choosing a Roth IRA and a traditional IRA. 

Roth IRA benefits (pros)

  • Because your contributions in a Roth IRA are made with the money left after you paid taxes, the potential earnings will see growth without taxes. 
  • You can withdraw your money from a Roth IRA without taxes and penalties at any time, without stating a reason. You can do this only if you made your first contribution at least 5 years ago or if your age is 59½. We recommend that you refrain from going into your retirement savings account. 
  • It’s not mandatory to withdraw a minimum amount from a Roth IRA, no matter what age you are.
  • You can keep your money in your Roth IRA for as long as you wish to grow without being taxed.
  • You get more savings after tax in retirement.

Roth IRA cons

  • As detailed previously, you can’t apply for a Roth IRA if your income is higher than the IRS limit.
  • You don’t get immediate tax benefits when making contributions.
  • If you want to withdraw your earnings (not savings) early, you might have to pay a penalty of 10% or income taxes, unless there’s an exception. 

Traditional IRA benefits 

  • You can use your money without any penalty after age 59½.
  • Your potential earnings will grow tax-deferred. 
  • You’re not taxed until you reach retirement and withdraw the money.
  • There is no income limit.
  • Your contributions can reduce the taxable income in the year they were made. That is, if they are deductible.

Traditional IRA cons

  • If you take money out of a traditional IRA before the retirement age, you will have to pay income taxes on gains and taxable contributions.
  • Early withdrawal will also cost you a 10% penalty.
  • After age 72, you will need to withdraw a minimum amount of money. 

If you want to have a cozy retirement, it’s time to think about opening an individual retirement account. And if you want to learn more about your financial retirement options, we are here to help you reach your goals. 

How is an IRA different from 401k?

401(k) plans are associated with your employer and often offered on a pre-tax plan. A traditional IRA is independent of an employer but similar to a 401k in that contributions are pre-tax. Similarly, a Roth IRA is also separate of an employer, but contributions are from after-tax income.

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