Retirement planning can be overwhelming. Trying to decide when to start saving, how much, and how to do so is a lot to take in when planning for the future in an ever-changing world. As young adults starting to enter the professional arena with benefit packages that include retirement options, you are faced with choices you may not quite understand. So what exactly are the differences between Traditional and Roth IRAs?
Traditional IRAs are easy to understand on the contribution side, but a little trickier when retirement rolls around and you start taking distributions. To begin with, its easy to contribute to a traditional IRA if you are working and under the age of 70 ½. With a Traditional IRA the contributions you make may be deductible if you are under certain income limits. But what about the distributions? Traditional IRAs generally require the tax to be paid once you retire and begin to withdraw the funds. You can generally take withdrawals whenever you want, but you need to keep in mind a few rules. First, even if you are still working, with a Traditional IRA, you must normally start taking distributions at the age of 70 ½. Second, if you take a withdrawal before age 59 ½, you may have a 10% tax penalty in addition to any regular tax that you may have to pay on the distribution.
On the other hand, Roth IRAs are tricky on the contributions side but simple when it comes to distributions. Roth IRAs have contribution limitations that change every year and depend on your income and filing status. The contributions are “post-tax” meaning that you won’t ever receive a tax deduction for any deposits you make to a Roth IRA. However, when it comes time to retire, the distributions are tax free! Unlike Traditional IRAs, early withdrawals of contributions may be tax free under certain circumstances. The interest earned on those contributions may be penalized if taken before age 59 ½. There are no required distributions for Roth IRAs which means your money can stay in the account and continue to grow even after 70 ½. The key takeaway is that Roth IRA contributions may be limited, but are generally tax-free when distributed.
So which is best? Only you can decide that, but when choosing between Roth and Traditional IRAs consider your current tax bracket and what you think it may be in the future. If there is a chance that your tax bracket will increase over the years and remain higher upon retirement, it may be best to contribute to a Roth IRA so that no taxes will be paid at a higher rate. If you are currently in a high bracket and don’t think that will change much in the future Traditional IRA contributions can help offset current tax liability and the taxes paid in future years may not be so bad if income is lower upon retirement. Also, in certain situations, it may be beneficial to have both a Roth IRA and one Traditional IRA. This strategy may allow you to receive some tax benefits now and some later. It may also allow you to have some tax flexibility when you begin making distributions. Simply put, this best of both worlds strategy may help you to have more options to achieve your financial goals.