Knowing where to invest your money to serve you best in retirement can feel daunting. With all the available options and different types of accounts for a diverse portfolio, it can take time to understand the differences between account types.
Individual Retirement Accounts (IRAs) are a popular option when saving for the future.
There are two main types of IRA accounts: Roth IRA and Traditional IRA. Both the Roth and Traditional IRAs have their benefits and drawbacks. Understanding the ins and outs is essential before deciding which account suits you.
Here are 11 key points to consider when choosing a Roth IRA vs Traditional IRA.
How Traditional and Roth IRAs Differ
With the ever-increasing cost of living, setting aside money for retirement is becoming exceedingly important. Knowing the pros and cons of different investment options is vital to ensuring a comfortable future.
There are two main differences between a Roth vs Traditional IRA:
- Contributions to a Traditional IRA are usually tax-deductible, while contributions to a Roth IRA are not
- Distributions from Roth IRAs are typically tax-free, whereas distributions from Traditional IRAs are taxable
Having these account options at your disposal can help you maximize savings over your lifetime while monitoring changes in income and tax brackets year after year. With the right strategy, you can set yourself up for financial success in future years.
Income limits for contributions
When deciding between a Roth and Traditional IRA, one of the primary considerations is understanding your eligibility to contribute. Income limits are associated with each option.
In 2023, the maximum contribution amount for both Roth and Traditional IRAs is $6,500, or $7,500 if you are over 50. From this point, restrictions can apply, making your eligibility less than the maximum allowed.
With Roth IRAs, you can contribute to your account if you make below a certain amount annually. But on the other hand, Traditional IRAs contribution eligibility has an upper limit but no lower limit annual income requirement.
So, depending on your income level this year, one type of IRA is more suitable than the other for maximizing return and taking advantage of new tax deductions before the end of the current financial year.
When can you withdraw your money?
Knowing when you can access your money in a Roth IRA vs Traditional IRA is critical to leveraging their benefits.
For Traditional IRAs, you only pay taxes on the contributions once you start taking withdrawals from your account in retirement when you are likely to be in a lower tax bracket. However, once you turn 70 1/2, you must take “required minimum distributions.”
With Roth IRAs, various options exist for accessing your money early; contributions can be withdrawn anytime without penalty. Qualified distributions (made after five years) associated with the earnings within the account are also allowed, but they may incur taxes.
Both accounts have no age limit to start making withdrawals, so starting early or late both have advantages within each type of account.
What tax bracket will you be in at retirement?
Anticipating your retirement income tax bracket can significantly affect which IRA you choose.
Because a Roth IRA deals with after-tax dollars, and a Traditional IRA deals with before-tax income, determining the tax bracket you pay contribution tax in is essential to consider.
When you decide to withdraw funds from the account, the Roth IRA withdrawals will be tax-free, while a Traditional IRA yields no taxes until withdrawal.
If you anticipate your tax bracket will be higher when you retire than it is now, a Roth IRA may give you more savings in the long run. If you anticipate your tax bracket is higher now than when you retire, going the Traditional IRA route could be the better option for you.
The goal is to be taxed at the lowest tax bracket possible and take advantage of tax advantages, whether now or in the future, to maximize your account growth.
Other factors to consider
Before deciding on a Traditional or Roth IRA, here are some other points to consider while determining what works best for your goals.
Investment options:
Review the types of investments available within each account – not all accounts offer access to the same assets. Depending on which type of IRA you choose, different investment options can help maximize your savings and grow your portfolio.
Traditional IRAs can access stocks, bonds, mutual funds, and ETFs. Roth IRAs also benefit from allowing access to alternative investments such as real estate, precious metals, and cryptocurrencies.
Depending on the provider’s offerings, some accounts also allow investing directly into individual companies or actively managed funds. With so many choices available, it pays to research before deciding what investments you should make with your IRA account.
If you partake in an employer-sponsored retirement plan:
Whether you are or you aren’t covered by an employer-sponsored retirement plan, it can affect contribution and deduction amounts to your Roth and Traditional IRAs.
To make tax-deductible contributions to a Traditional IRA, your eligibility is based on your income level and whether you participate in an employer-sponsored retirement plan.
For example, suppose you do participate in an employer plan. In that case, the amount of money deductible from taxes may be reduced or eliminated depending on how much you earn each year.
With a Roth IRA, having an employer-sponsored retirement plan does not affect your ability to contribute. Therefore, all individuals with earned income can contribute regardless of participation in such plans.
If you have a large taxable income:
The more money you make, the fewer tax deductions and credits you’re eligible for based on your filing status. In this situation, opting for a Roth IRA is better, as your contributions will not be deductible from taxes.
Age restrictions for IRA contributions:
Contributions to a Traditional IRA must cease by the age of 70 1/2. In contrast, contributions to a Roth IRA may continue for as long as you have earned income.
Depending on the age you plan to start your IRA, the overall contributions you can make may be affected. For example, if you are 65 and looking to open an IRA, a Roth IRA may be a better option because you have no age restriction on contributions as long as you earn an income.
However, if you opted for the Traditional IRA, you would only have about 5 years to contribute to your IRA, which may not yield enough growth to contribute to your financial goals.
Costs and fees associated with each type of account:
When considering a Roth or Traditional IRA, it is essential to consider the associated fees and costs. While both offer tax advantages for retirement savings, each type of IRA has different fees. For instance, some Roth IRAs may have higher fees than Traditional IRAs.
The costs and fees can differ from provider to provider. Therefore, speaking to your financial planner can help you understand these additional costs better.
Penalties:
Penalties exist for early withdrawals of funds if you are under the age of 59 1/2 and you contribute excess funds.
If you contribute over the allowed limit, you will be notified to withdraw the excess funds by a specific date.
Examples of Excess Contributions:
- Contributing over your limit
- Making normal contribution payments to your Traditional IRA over the age of 70 1/2 in 2019 or earlier
- Improper rollover to an IRA
If you do not comply, a 6% fee will be applied every year the extra funds are in your account.
Marital status and Living Situation:
Marital status is a factor in determining which type of IRA works best for you. For example, if you are married filing jointly or married filing separately, your contribution limit will differ depending on whether you lived with your spouse during the year.
Also, suppose an employer-sponsored retirement plan covers one spouse while the other doesn’t. In that case, contribution limits may also differ between them.
Therefore, it’s essential to consider these factors when deciding between a Roth and Traditional IRA, as they can affect eligibility for tax deductions and credits and overall contributions.
Contact a Licensed Financial Planner
Choosing between a Roth IRA and a Traditional IRA can feel overwhelming. However, by assessing multiple factors like your income level, age restrictions, and costs and fees associated with each type of account, you can make an informed decision to help you achieve your retirement savings goals.
Contact a licensed financial planner to build a solid plan for your financial future. A trusted financial planner will discuss what options best suit your retirement goals and ensure that you take advantage of all available benefits.
A good planner will help walk you through the details of each account and explain why one may work better for your situation than another. They can also advise on savings and other strategies to help you save more for retirement.
With the most up-to-date information on benefits and limits in their hands, you’ll be well-positioned to pick the perfect plan to maximize your growth potential while allowing for flexibility as life changes.
If you are ready to talk with a financial advisor at Iron Point Financial, call today to make an appointment or schedule one online. We are here to help you make informed decisions so you can confidently make a plan to work toward your financial goals.
