Individual retirement accounts (IRAs) are vital to your retirement strategy. But one of the big decisions is the choice between a traditional IRA and a Roth IRA. Both have their advantages, and choosing between the two can significantly impact your retirement savings. Let’s break down the differences so you can make the right decision to ensure your hard-earned savings perform as well as possible.
The Tax Factor
The primary difference between a traditional IRA and a Roth IRA is the tax structure.
- With a Roth IRA, you contribute funds on which you’ve already paid income taxes, sometimes called “after-tax dollars” or “post-tax income.”
- With a traditional IRA, you contribute money that has not yet been taxed, known as “pre-tax income.”
If you predict you will be in a higher tax bracket in your retirement phase than you’re in currently, you should contribute post-tax income to a Roth IRA. You may be paying income taxes up front, but you’ll probably save money on the potential withdrawal taxes during retirement.
On the other hand, a traditional IRA is preferable if you predict that your tax bracket will be lower during retirement. You’ll pay income taxes on your retirement withdrawal, but the taxes will probably be much less than you would pay in your current high tax bracket were you to opt for a traditional IRA.
Many people need to access their IRA funds before their retirement years. For those anticipating early withdrawal, a Roth IRA is much more flexible. Since you’ve already paid taxes on the funds in your Roth IRA, you can make tax-free and penalty-free withdrawals at any time.
On the other hand, withdrawals from traditional IRAs are usually only available without taxes and penalties once you turn 60.
Required Minimum Distributions
Required Minimum Distributions (RMDs) are the minimum amount a retirement plan owner must withdraw annually starting either the year they turn 72 or the year they retire if they stop work after 72. There are no RMDs with a Roth IRA. However, all other tax-advantaged retirement accounts require you to begin withdrawing funds once you turn 72.
Annual RMD amounts are calculated on your life expectancy and total account balance, although you’re under no obligation to spend your RMDs once they land in your account.
How to Choose Between a Roth IRA and a Traditional IRA
The tax factor is the paramount consideration between the two IRA options. If your taxes will be higher in the future, go for the Roth, and if lower, go with the traditional. That said, the versatility of early withdrawals makes the Roth a little more appealing than the traditional IRA.
The problem, however, is that it’s not always easy to determine your tax status post-retirement. So consider contributing to both. Contribute a percentage of your budget to a traditional IRA to get tax benefits today, while simultaneously contributing to a Roth IRA to get possible tax benefits down the road.
So which IRA wins? They’re both efficient and beneficial and choosing to diversify in a bit of both could very well be your best option.