What's the difference between a savings account and a Roth IRA?
Put simply, a basic savings account is typically considered an account that you open at an FDIC insured bank that earns interest, and that interest is taxed by the government each year that it's earned. Usually, a savings account is attached to a checking account, so folks can transfer money into checking to pay bills. A more technical term for this type of account is a "non-qualified" account, since the earnings are not qualified for any type of tax haven treatment.
By comparison, a Roth IRA is a "qualified" account that allows certain tax-filers the ability to deposit money today and defer paying taxes on those funds in retirement (for more info on Roth IRAscheck out this IRS page). There are income thresholds that dictate how much you can, if at all, contribute to these types of accounts. Once you contribute, there are many investment options from FDIC insured savings to aggressive investment options.
A savings account is a deposit account held at a retail bank that pays interest, but usually cannot be used directly as money in a checking account with check writing privileges. Savings accounts let customers set aside a portion of their liquid assets while earning a monetary return versus other types of accounts such as a checking account or money market account.
Whereas a Roth IRA is a type of IRA (Individual Retirement Account) in which you pay taxes on money going into your account and then all future withdrawals are tax-free. There are annual contribution limits each year dependent on personal variables. IRA contributions are the lesser of your taxable income and the published limit amounts dependent on age, filing status, and income each year. This total may be split up between any number of traditional and Roth IRAs. You may contribute to a Roth IRA at any age as long as you have income.
Your Roth IRA can be invested in, but not limited to stocks, bonds, mutual funds, unit investment trusts, ETFs, and/or real estate limited partnerships. As with all IRAs, the IRS mandates specific eligibility and filing status requirements. A Roth IRA's main advantages are its tax structure and the additional flexibility that this tax structure provides.
A savings account is a bank account where the deposits that you make earn interest. Savings accounts are generally used for money you need to keep 'safe' for a relatively short period of time (1 day -3 years or more). Examples of how savings accounts are often used include saving for: emergency funds, educational expenses, vacations, planned holiday spending, down payments for a home or cars. Savings accounts pay interest that is taxable. You will receive a 1099 INT every year to report the interest you earned on your income taxes.
A Roth IRA is generally used as a retirement savings account. Deposits can be invested into stocks, bonds, and other investments as well as be held in money market accounts. Your invested returns are not guaranteed. So, any stock and bond investments you have will carry the risk of loss.
Monies deposited into these accounts should generally be thought of as long-term savings (not needed for 5 years or many more).The money deposited into these accounts has already been taxed. But, the three sweetest things about Roth IRA accounts are that:
- The account grows tax free (no 1099 INT or 1099 DIV every year).
- When the money is withdrawn from the Roth IRA (subject to a minimum holding period) is tax free.
- When you turn age 70 1/2, you are not required to take money out of your account in the form of a withdrawal known as an RMD -required minimum distribution.
As with anything relating to taxes and the government, there are rules for Roth IRAs. I mean lots of rules. Some of which include: you must have earned income, can only contribute up to a certain income level, there are annual contribution maximums, you have to have an account open for 5 years before taking penalty-free withdrawals that include earnings, and then there's that pesky age 59 1/2 rule.
For more information, Investopedia has an article on Roth IRAs and there is always the IRS web site which gives a brief overview on Roth IRAs and then refers you to its Publications 590-A and 590-B for the nitty-gritty details and rules.
There are a host of differences between a savings account and a Roth IRA.
First, a savings account is typically offered through a bank. As a bank deposit, these funds are guaranteed by depositor insurance in case the financial institution were to fail. Because these accounts have little risk, you are paid an interest rate that reflects this. You'll find savings account interest rates hover near 0%. You'll also receive a Form 1099-INT from the bank annually (assuming you earn at least $10 per year in interest) that will also be reported to the IRS. You'll have to include this interest income on your tax return which will become part of your taxable income. Savings accounts are great vehicles to build up money that you can access for emergencies or unexpected expenses.
A Roth IRA is a retirement account. You can set these up through a bank, brokerage firm, mutual fund company, or an investment management account through a Registered Investment Advisor.
With a Roth IRA, you'll have access to a variety of investments beyond just a money market account, which is the closest approximation with a bank savings account. You may invest in stocks, bonds, mutual funds, unit investment trusts, master limited partnerships, and more. You have a greater potential for gain and accordingly have more risk and exposure to volatility in returns.
Unlike a savings account, you do not need to pay taxes on earnings (dividends, interest or capital appreciation) each year. And in retirement, you do not pay income on these earnings either. Why? Because you don't take a tax deduction for contributions to a Roth, you are investing "after-tax" money" so you don't pay taxes on the gains later when you make withdrawals in retirement.
Another feature of a Roth IRA is that you don't have to take distributions in retirement. Unlike a traditional IRA or your 401(k) plan at work, you are not required to take any distributions. You could, in effect, choose to let the money compound through retirement and then potentially leave a bigger pie as a legacy for your beneficiaries who inherit the funds.
Unlike a savings account, there are limits on how much you can contribute each year based on your age and adjusted gross income.
One great feature of a Roth IRA is that you can access your principal (what you contributed from time to time) without a tax penalty for early withdrawals. There are exceptions that allow investors to access the funds to help pay for college or a first-time home purchase. This is why these are great savings vehicles by parents of college-bound students or by students themselves. Unlike a 529 savings plan which requires the funds to be used for qualified education expenses, a Roth IRA can be used for other things allowing more flexibility. So a parent wouldn't have to tie up funds in a 529 for a student who might not use the funds because he chose not to go to college or trade school, or received a scholarship and didn't need the 529 funds.
A savings account is an all-inclusive term , which includes IRAs and regular ( non-retirement) savings. A Roth IRA is a savings account in which earnings accrue on a tax-deferred basis, but are tax free if distributions are qualified. In a regular savings account, earnings are added to an individual's taxable income for the year earned.
Check out Tax Treatment Of Roth IRA Distributions for an analysis of Roth IRA distributions and examples and explanations of the circumstances under which earnings in a Roth IRA would (or would not) be subject to income taxes.
This question was answered by Denise Appleby