I often get questions from both new and old investors wanting to know which is better– a traditional IRA or a Roth IRA? So, I wanted to give you a snapshot of what each of these types of retirement accounts can do for you. Setting yourself up for financial freedom, especially in your retirement years, is an important thing to do. Some people do this through retirement accounts, and other do this through various investment strategies. Roth IRAs and traditional IRAs are just one of many paths that lead to financial freedom during retirement.
How to Invest for Retirement with an IRA
A Traditional IRA is an Individual Retirement Account to which you contribute pre-tax or after-tax dollars. This allows your money to grow tax-deferred. When you make withdrawals after age 59½, they’re treated as current income.
The money you deposit in your IRA isn’t taxed. Whatever earnings you have on your contributions won’t be taxed until you withdraw that money many years later. Traditional IRAs have no annual income limits on contributions. So, it does not matter how much or how little you make. Anyone can contribute to a traditional IRA. Most employers that sponsor retirement accounts feed into traditional IRA’s. If your job offers that benefit, take it!
A Roth IRA is an individual retirement account that offers a valuable future tax break: tax-free income in retirement. Like beauty, the benefit of a Roth IRA is in the eye of the beholder. It all depends on the beholder’s tax bracket–both now and when he or she retires.
Although there is no up-front tax deduction for Roth IRA contributions as there is with a traditional IRA, Roth distributions are tax-free when you follow the rules. And because every penny you stash in a Roth IRA is your money—not a tax-subsidized gift from Uncle Sam—you can tap your contributions (but not your earnings) any time tax-free and penalty-free.
Roth IRAs do have annual income limits. For the 2020 tax year, you can contribute to a Roth IRA if your modified adjusted gross income is less than $139,000 for singles and $206,000 for couples. Tax-free income in retirement is a truly great deal. A Roth IRA is a great investment for young people!
The benefit of either IRA is that they both provide generous tax breaks, but it’s a matter of timing when you get to claim them. Traditional IRA contributions are tax deductible on both state and federal tax returns for the year you make the contribution. However, withdrawals in retirement are taxed at ordinary income tax rates. Roth IRAs provide no tax break for contributions, but earnings and withdrawals are generally tax-free.
So with traditional IRAs, you avoid taxes when you put the money in. With Roth IRAs, you avoid taxes when you take it out in retirement. Since both types of retirement accounts can be beneficial, you can actually have one of each. You just have to pay careful attention to not go over the contribution limits.
You can open a Roth IRA and a traditional IRA at many different types of financial institutions, such as banks, credit unions, and even brokerage firms. The minimum for opening the account is determined by the financial institution and the maximum contribution is determined by the government.
Whichever account or investment you choose to help you towards the goal of financial freedom at retirement isn’t necessarily important. What is important is that you are taking steps to build wealth for your retirement.
So, what steps ARE you taking to set yourself up for financial freedom for retirement?