Let’s start with the basics. IRA stands for individual retirement account and just about anyone can open one. In order to contribute to an IRA you must have earned income. Traditional IRAs and Roth IRAs have many similarities, but there are distinct benefits to each.
IRA Contribution Limits
The IRS limits how much you can contribute to an IRA each year. Contribution limits for traditional and Roth IRAs are the same, in 2017 you can contribute up to a maximum of $5,500. If you’re over the age of 50 you can make an additional $1,000 catch-up contribution for a total of $6,500.
Tax-Deferred Growth in IRAs
When you invest money in an IRA the funds you contribute grow over time depending on the investments you choose to hold in the account. Both traditional and Roth IRAs benefit from tax-deferred growth, meaning you won’t have to pay taxes every year on interest, dividends or capital gains like you would in a non-retirement account. This helps your investments grow even faster by way of compounding growth. (For related reading, see: A Beginner's Guide to Tax-Efficient Investing.)
Retirement Withdrawal Rules
It’s called a “retirement” account for a reason—the money you’re saving is designated for retirement. That means if you withdraw funds from an IRA early, before age 59.5, the IRS will assess a 10% early withdrawal penalty. Don’t do that!
Benefits of a Traditional IRA
When you contribute money to a traditional IRA you’ll typically receive a tax deduction, dollar for dollar, up to the amount you contributed. For example, if you earn $50,000 and contribute the $5,500 maximum to your traditional IRA, when you file your taxes the deduction will make it so you only pay taxes on $44,500 of your income. Therefore, the money you contributed to the IRA hasn’t been taxed yet. The key word here is “yet;” the IRS will collect their taxes later. When you take distributions from the account, after reaching age 59.5, you will owe income taxes on every penny you withdraw, both contributions and growth. (For related reading, see: How Much Are Taxes on an IRA Withdrawal?)
Benefits of a Roth IRA
In terms of taxes, the Roth IRA is the complete opposite of the traditional IRA because you get the tax benefit when you take money out, not when you put it in. Using the same example, if you earn $50,000 and contribute the $5,500 maximum to your Roth IRA, you still pay income tax on the full $50,000 you earned that year. Therefore, the money you contribute to a Roth IRA has already been taxed. But when you take distributions after age 59.5, you pay nothing in taxes. Roth accounts are the only type of retirement savings that allow you to withdraw both contributions and growth tax-free.
Some Restrictions on IRAs
Earlier we mentioned you must have earned income to make contributions to an IRA, the only exception is if you’re making contributions for a spouse or minor children. That said, if you earn too much income, the IRS may disqualify you from making direct Roth IRA contributions or being able to deduct traditional IRA contributions. These income thresholds change over time and you can find the most current numbers on the IRS website. (For related reading, see: The Benefits of Starting an IRA for Your Child.)
Which Is Better, Traditional or Roth IRA?
The answer to that question depends on your personal situation; clearly there are great benefits to both. Ideally you’ll want to do your best to balance both of these tax benefits.
If you earn a fair amount of income and don’t have many deductions, the traditional IRA may be best. That’s because getting a tax deduction in the current year will keep more money in your pocket and you’ll pay less income tax. But if you have a longer time until you retire or aren’t concerned with current taxes, you may benefit more from the Roth IRA. Having retirement investments grow with compounding interest and not paying taxes when you withdraw funds is definitely compelling. (For related reading, see: Achieve Your Financial Goals With a Financial Plan.)
The good news is, no matter which you choose you’ve made a great decision because saving for retirement is always a good thing! (For more from this author, see: Credit Report vs. Credit Score: What You Need to Know.)