A Layman's Guide to Traditional and Roth IRAs

Some of the most frequent questions our clients ask are related to IRAs. What is the purpose and benefit of an IRA? What is the difference between a traditional IRA and a Roth IRA? The purpose of this article is to help clear up some of the confusion.

What Exactly Is an IRA?

IRA stands for "individual retirement account." The key word here is account. An IRA is like a bucket to hold investments, so it is not considered an investment on its own.

In other words, if you are looking to invest in a particular mutual fund you can do this inside of an IRA account set up by a bank or brokerage firm. IRAs are simply the container in which individuals can invest on a tax-preferred basis.

How Does an IRA Differ From a Regular Investment Account?

The biggest difference between an IRA and a regular investment account is in the tax advantages. IRAs were designed to help individuals build their retirement nest egg. Social Security is often not enough to fund a desired retirement lifestyle, and IRAs are a great way to supplement retirement income.

Traditional IRA

A traditional IRA is made up of pre-tax dollars. In other words, each time you contribute to a traditional IRA, it reduces your taxable income in that tax year. If you have a 401(k) plan through your employer, you can later roll the money from the 401(k) plan into your traditional IRA account if you happen to leave your job. (For related reading, see: 5 Secrets You Didn't Know About Traditional IRAs.)

Once money is in your traditional IRA account, you can choose how it should be invested. Maybe you want to invest in individual stocks, an exchange-traded fund, or mutual funds. You have control over that.

While IRAs do offer flexibility for withdrawals, you should never take the money out before you are ready to retire. If you withdraw funds from a traditional IRA prior to age 59.5 you will have to pay normal income tax in addition to a 10% early withdrawal penalty. This ends up being a hefty price to pay to access the funds. Even in high-need situations, it just isn’t worth it.

When you reach retirement age and are ready to withdraw from your traditional IRA, know that every time you withdraw or take a distribution the money will be taxed at regular income tax rates. So let’s say over the years you’ve contributed $100,000 and, because your investments did well, it has grown to $300,000. When you withdraw this money, all of it will be taxed as income during the year it is withdrawn.

Roth IRA

Contrary to a traditional IRA, a Roth IRA is made up of after-tax dollars. In other words, contributions to a Roth IRA do not reduce your taxable income.

At first glance, it may seem like a bad deal. However, the real benefit of a Roth IRA comes when you go to withdraw the funds. Withdrawals from a Roth IRA are made tax-free, including all the investment growth. This can be a huge tax benefit. (For related reading, see: Roth vs. Traditional IRA: Which Is Right for You?)

IRA Limitations

Because of the big tax advantages offered by IRAs, the government limits the amount investors are able to contribute annually. This prevents people from taking advantage of the tax code. Both traditional and Roth IRAs have 2017 contribution limits of $5,500 annually if you are under the age of 50, and $6,500 if over 50. Uncle Sam wants you to have access to tax advantaged accounts, but he doesn’t want you to get carried away.

Summary

The chart in this article goes over some of the key differences between Traditional and Roth IRAs. When thinking about whether you want to start a Roth or traditional IRA, start by asking yourself if would you rather pay the taxes now or later. There are many other nuances with IRAs that are important to keep in mind, but these are the basics.

 

(For more from this author, see: 5 Things to Do in Your 20s to Retire in Your 50s)

 

If you are considering rolling over money from an employer-sponsored plan, such as a 401(k) or 403(b), you may have the option of leaving the money in the current employer-sponsored plan or moving it into a new employer-sponsored plan. Benefits of leaving money in an employer-sponsored plan may include access to lower-cost institutional class shares; access to investment planning tools and other educational materials; the potential for penalty-free withdrawals starting at age 55; broader protection from creditors and legal judgments; and the ability to postpone required minimum distributions beyond age 70.5, under certain circumstances. If your employer-sponsored plan account holds significantly appreciated employer stock, you should carefully consider the negative tax implications of transferring the stock to an IRA against the risk of being overly concentrated in employer stock. You should also understand that Commonwealth and your financial advisor may earn commissions or advisory fees as a result of a rollover that may not otherwise be earned if you leave your plan assets in your old or a new employer-sponsored plan and that there may be account transfer, opening, and/or closing fees associated with a rollover. This list of considerations is not exhaustive. Your decision whether or not to roll over your assets from an employer-sponsored plan into an IRA should be discussed with your financial advisor and your tax professional.