Finance Basics: Traditional IRA vs Roth IRA

You’ve seen these letters floating around out there. What do they mean? Should you open one? Which one?

Wonder no more! Let’s talk retirement accounts!

What is an IRA?

An IRA, also called a Traditional IRA, is a retirement account. Think of it like an envelope that can hold money or investments.

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The powerful thing about IRAs is how they’re taxed.

Money you contribute to an IRA might be deducted from your overall income when it comes to pay taxes. This translates to paying fewer taxes each year!

Not only that, but investments you make in an IRA can grow tax free. In a normal brokerage account, buying and selling stocks might expose you to capital gains taxes. Or you might have to pay taxes on any dividends you receive.

You don’t have to worry about that in an IRA.

Tax deferment, and tax free growth. What’s the catch?

The catch is that the IRS will eventually get its cut. When you retire and pull money from the account, any withdrawals you make will count as ordinary income.

These are also meant to be used in retirement, so any withdrawals before you reach age 59 ½ will have a 10% penalty attached to it, on top of being taxed. Fortunately, there are exclusions. You don’t incur the penalty if you are using the money for certain situations such as purchasing a home, education, or disability.

What is a Roth IRA?

A Roth IRA is very similar to a traditional IRA, just flipped. You pay taxes when you put the money in, but then you’ll be able to withdraw the money tax free.

One of the other differences with a Roth IRA is that you can withdraw your *initial contributions* tax free. So, if you contribute $5,000, and it grows to $10,000, you’ll be able to withdraw $5,000 without incurring the withdrawal penalty.

Which is the right choice for you?

The rule of thumb is: Pay taxes at the lower level.

Do you think you’ll be in a higher tax bracket now, while you’re working, or later, when you’re retired?

Most people get very excited by Roth IRAs, and the prospect of not needing to pay taxes again in the future. However, that might not necessarily be the best move. The tax deferment that Traditional IRAs give you is so powerful, especially over a long period of time, that a Traditional IRA is still often the correct choice.

On top of which, as you get closer to retirement, you have an opportunity for a financial maneuver called a “Roth Conversion.” In a Roth Conversion you can convert money from a Traditional IRA to a Roth IRA. Used successfully, you get the benefits of both the IRA and the Roth IRA, but it takes some planning.

A whole article could be devoted to Roth Conversions, and so one will! For now, let’s just sum up by saying: You can contribute to your IRA only as long as you’re earning money, but you can do Roth Conversion until the day you die. For many, contributing an IRA now so you can do a Roth Conversion later ends up being a pretty good move.

Let’s cut to the chase

The choice between your IRA and a Roth IRA depends largely on your tax bracket, and what you expect your future career to look like.

If you’re having trouble deciding between a Roth IRA and a Traditional IRA, click here to sign up for a Free Bronze Account. A licensed financial advisor will reach out to you with a complimentary 60-minute strategy session in which they’ll be able to explain which would be the best choice in your specific financial circumstances.

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