There are many ways to save for retirement, but an independent retirement plan, more commonly known as an IRA, is one of the most popular paths. Unlike a 401k, which requires employer participation, individuals can start an IRA on their own.
However, there are many types of IRAs, including Roth and traditional IRAs. That leaves many new investors wondering which they should invest in.
As is the case with many financial decisions, there is no one-size-fits-all approach. But you can make the best decision for your existing circumstances and financial goals by asking these basic questions.
What Are The Tax Benefits Of Roth And Traditional IRAs?
Both Roth and traditional IRAs offer tax breaks, but when and how you get them depends on which IRA you choose. This is one of the primary differences between the two types of IRAs.
When you invest in a traditional IRA, contributions are tax-deductible on both federal and state taxes in the year they were made. You’re then taxed when you withdraw from your IRA, which usually takes place once you’re retired. If you withdraw early, which is before you’re 59 1/2 years old, then you’ll need to pay a penalty, but we’ll get to that in a later question.
Conversely, when you make contributions to a Roth IRA, you don’t get a tax deduction upfront. However, when you withdraw funds during retirement, you can typically do so tax-free.
What Do You Think You’re Annual Income Will Be When You Retire?
This question really builds on the last one, offering reasons you may want to choose one or the other. Because Roth and Traditional IRA contributions are taxed at different times, your tax bracket and therefore rate at the time of retirement can help you determine which IRA is better.
If you’re relatively sure that you’ll be in a higher tax bracket in retirement, a Roth IRA may be a better option. That’s because your tax benefit is delayed. In this case, you may end up paying less in taxes since a portion of your contributions will be made while you’re in a lower tax bracket.
If, however, you think you’ll be in a lower tax bracket at retirement, then you may want to consider a Traditional IRA, which will give you immediate tax advantages.
Do You Meet The Basic Eligibility Requirements For A Roth Or Traditional IRA?
Traditional IRAs have very few eligibility requirements. Ultimately, anyone who is under 70 ½ and earning a taxable income can open a traditional IRA.
A Roth IRA, on the other hand, doesn’t have an age requirement, but there are income limits that can prevent you from leveraging that particular type of IRA.
For instance, if you are married filing jointly, you won’t be able to contribute to an IRA if you’re income is equal to or greater than $203,000. If you’re married filing separately but lived with your spouse at any time during the tax year, you won’t be able to contribute to a Roth IRA if your income is equal to or more than $10,000.
Roth contribution allowances vary based on filing status and income, and therefore the best way to determine where you fit is to consult the most up-to-date Roth IRA contribution requirements located on the IRS website.
Do You Anticipate Making An Early Withdrawal?
Early withdrawals aren’t recommended, but that doesn’t mean they’re always avoidable. If you think there’s a reasonable chance that you may need to break into your retirement savings early, then a Roth IRA may be best.
With a Roth IRA, you can draw from what you contributed – not what you’ve earned in interest – at any time without penalty. If you attempt to draw from your traditional IRA early, you may face a significant 10% penalty.
That said, some circumstances will allow you to withdraw from your traditional IRA without facing that hefty penalty. This includes qualifying educational expenses, home purchases, and medical expenses. You can also withdraw without penalty if you become disabled, and your account beneficiary can withdraw in the event of your death.
Roth and traditional IRAs can be a great way to save for retirement. In order to make the most of your investment, it’s important to understand the differences between the two. By asking the questions above, you can identify your short and long-term needs and identify the best IRA for you.