Today we shall look at Roth IRA versus Traditional IRA. The main aim of this article is to establish the differences between the two types of IRAs, in a bid to enable you to know which one is right and best for you. If that sounds good to you, then read on till the end of this article to find out more.
Traditional IRAs and Roth IRAs mainly differ in how and when an account holder’s money is taxed. Depending on your financial goals and objectives, either can be good for you or not good for you. You, as such, have to be very careful when making your choice, to ensure that you do not make the mistake of choosing one instead of the other, then ending up losing more money than was necessary, in the form of taxes.
Here’s how you can choose the account that is best for you.
Roth IRA Vs Traditional IRA: Which one do I choose?
The main difference between these two types of IRAs, as already highlighted, is when and how you get taxed. For a traditional IRA, all the contributions you make to the account are tax-deductible, but the withdrawals you take upon retiring are taxable. With a Roth IRA, on the other hand, your contributions to the account are not tax-deductible, but all the withdrawals you take upon retiring are tax-free.
Depending on the outlook of the global economy, and your set retirement goals, you can choose the type of IRA that will best favor your objectives. Here are some other features of the traditional and Roth IRAs that are worth considering as you make your decision.
- The is a no-immediate tax benefit for the contributions made.
- One can withdraw their contributions at any time without being taxed or penalized
- Your ability to contribute to your Roth IRA is phased out if you have a high income
- All the qualified withdrawals during retirement years are tax-free.
- The contribution limit is $6000 (or $7000 for those 50+ years – the extra $1000 is known as a catch-up contribution).
- If deductible, all the contributions you make will reduce your overall taxable income in the year that you make them.
- Your deductions can be phased out depending on your current income.
- All your distributions during your retirement years will get taxed as ordinary income.
- Upon hitting age 72, you will be required to take the Required Minimum Distributions (RMDs).
- All unqualified/ early withdrawals attract a 10% penalty that’s accompanied by the income taxes
- Contribution limit is $6000 (or $7000 for those 50+ years)
Generally, if you are asking yourself whether or not to open a Roth IRA vs a Traditional IRA, the main question to ask yourself is whether you expect the tax rates to be higher in the future than they are in the present moment.
If you can answer this question with certainty, then you can without a shadow of doubt choose the account that’s best for you, as you look forward to making maximum tax savings.
Also, if you foresee a situation in which you will be in the higher tax bracket during your retirement years, then you should highly consider opening a Roth IRA, owing to its delayed tax benefit. If, on the other hand, you suspect that you will have lower rates during your retirement years, a traditional IRA is good for you, since it has the upfront tax advantage.
The truth of the matter, however, is that it’s hard to establish what your tax rate during retirement will be, more so if you are a couple of decades away from downing your tools of work. The good news, however, is that there are some other ways through which you can determine whether a Roth IRA or a Traditional IRA is best for you.
Checking your eligibility
Based on the IRS rules on IRA eligibility, you can decide whether a Roth IRA or Traditional IRA is best for you. Your annual income will determine:
- Whether you are eligible to contribute to a Roth IRA.
- The amount of money you contribute to your traditional IRA can be deducted from your annual taxable income. Note that your traditional IRA deductibility is restricted only in the case that you or your spouse can access a workplace retirement savings plan such as a 401(k)
- If you do not qualify for a Roth IRA but you still prefer opening one, you can try opening a backdoor Roth IRA.
- You can also decide to contribute to a Roth IRA and a Traditional IRA at the same time provided that your total contributions do not go beyond the set contribution limits ($6000 for those below 50 years, and $7000 for those aged 50 or more).
Why do most people prefer Roth IRAs?
You do not have to act based on what is popular, but it also doesn’t hurt to know why people opt to make decisions in the manner in which they do. Here are some reasons why people tend to choose Roth IRAs:
You are not limited by the early withdrawal rules
Although it is not a good idea to make early withdrawals from a retirement savings account, there are times in which you may need some money without having to worry about paying income taxes. In this case, a Roth IRA is suitable for you.
No Required Minimum Distributions
Unlike a Traditional IRA, you are not required to start taking Required Minimum Distributions upon hitting 72 years. This presents you with the freedom to let the funds in your IRA grow for as long as you want them to.
Depending on how disciplined you are at saving, you will end up with more after-tax money by opening a Roth IRA
As much as both types of IRAs offer tax breaks, there happens to be an overlooked benefit when it comes to the Roth taxes. Your tax breaks do not come until retirement, which eliminates the temptation of spending the money before then.
With a traditional IRA, on the other hand, the tax benefits come annually, and unless you are disciplined enough to reinvest them, you may end up spending this money on unnecessary flashy stuff.
The decision on whether to open a Roth IRA Vs. Traditional IRA is often a tough call for many, but you now have enough pointers to help you decide more easily. The IRS also allows you to open a self-directed IRA, which comes with more tax benefits and presents you with more investment options and choices.
Frequently Asked Questions on Roth IRA Vs Traditional IRA
1. How do I convert my traditional IRA to a Roth IRA?
Investors can convert their traditional IRA to a Roth IRA through one of the following ways:
- Rollover – Here, you receive a distribution from your traditional IRA that you are required to contribute to the newly-created Roth IRA within 60 days after receiving the distribution.
- Custodian-to-custodian transfer- You can authorize your traditional IRA custodian to transfer a specified amount of money to the custodian of the newly-created Roth IRA.
- Same custodian transfer – if your traditional and Roth IRA are overseen by the same institution, you can tell the custodian to transfer a certain amount of money from the traditional IRA to the Roth IRA.
2. Can I use my Roth IRA or Traditional IRA to invest in real estate?
No. The IRS does not allow you to use your Roth or Traditional IRA to invest in real estate projects. You have to create a self-directed IRA to invest in real estate projects and other non-traditional investments such as cryptocurrencies and precious metals.
3. Which assets am I not allowed to invest in through my traditional or Roth IRA?
The law prohibits investors from using their IRA funds to invest in collectibles or life insurance. For clarification purposes, collectibles include:
- Alcoholic beverages
- Tangible personal property
4. Are the Roth IRA rules similar to those of traditional IRAs?
Not all of them. Whereas most of the rules that govern Roth IRAs and Traditional IRAs are similar, there are some clear-cut differences, such as the time one gets a tax deduction. Whichever account you decide to open, therefore, you should take the time to understand the rules and regulations surrounding it, so that you can avoid getting hit with penalties and taxes by the IRS.
Check out some of our other posts on self-directed IRAs, rollovers, etc:
Also read: What is a 401(k) to gold IRA rollover?
That will be all for this article in which we have looked at Roth IRA versus Traditional IRA. I hope that you enjoyed reading it and gaining some new information on the two individual retirement accounts. Let me know if you have any questions about today’s topic or about self-directed accounts –drop them in the comments section and I will be more than happy to get back to you right away.
I wish you well,
Eric, Investor and Team Member at Gold Retired!