There are such things as good and bad retirement accounts, but which is which often depends on your situation. Take traditional and Roth IRAs, for example. They’re similar in a lot of ways, but one of them is probably going to offer you better tax advantages than the other. Here’s a closer look at some of the key differences between the two accounts so you can decide which one deserves your money.
1. When you pay taxes on your money
The biggest difference between traditional and Roth IRAs is that traditional IRAs use pre-tax dollars, while Roth IRAs use after-tax dollars. That means traditional IRA contributions reduce your taxable income for the year, while you owe taxes on your Roth IRA contributions. But when it’s time to withdraw funds, things flip. You can take your Roth funds out tax-free, but the government demands a cut of your traditional IRA withdrawals.
Both of them give you a tax break, so you might think you’ll come out about the same either way, but that’s not necessarily true. If you’re earning a lot of money right now, paying taxes this year might not make sense. You’re likely in a higher tax bracket, which means you’ll give more of your money back to the government. If you delay taxes until retirement, you’ll save yourself some money on taxes this year and possibly in the future. If your income is lower in retirement, you might end up in a lower tax bracket, helping you to hold onto more of your money.
But a Roth IRA could be better if you’re not earning a lot of money right now or you don’t believe your retirement spending will change significantly from your current income. In that case, paying taxes upfront is definitely the way to go, because you’ll only owe taxes on your contributions. Your earnings will grow tax-free.
2. Traditional IRAs have required minimum distributions
The government wants to make sure you withdraw your traditional IRA funds eventually so it can claim its cut. That’s why it institutes required minimum distributions (RMDs) for these accounts. As of 2024, the age for RMDs is 72 for everyone. Previously, individuals who reached 70 1/2 before 2020 had to begin RMDs at that time.
How much you need to withdraw depends on your age and IRA balance. If you had $100,000 in your IRA and you’re 72 this year, you’d divide the $100,000 by the 26.0 distribution period for 72-year-olds and you’d end up with approximately $3,846. This is the minimum you must withdraw from your traditional IRA this year, though you can take out more if you want. Failure to take out at least your RMD results in a 50% penalty on the amount you should have withdrawn.
Roth IRAs don’t have RMDs because you already paid taxes on those funds in the year you made your contributions, so you can leave them untouched as long as you want. This can give those savings more time to grow, so they could potentially be worth more in time.
If you decide you’d rather not deal with RMDs in retirement, you can always convert your traditional IRA funds to Roth IRA funds, but you must pay taxes in the year of the conversion if you do this. Whether or not that’s a smart move depends on your taxable income for the year and how you believe that compares to your spending in retirement, as discussed above.
3. You can take penalty-free Roth IRA withdrawals from your contributions at any time
Because you’ve already paid your taxes on your Roth IRA contributions, you can take them out at any time without paying taxes or a penalty. This means you have greater access to your own money, whether it’s for an unexpected expense, a first home purchase, or simply a change in plans. However, don’t forget that early withdrawals of earnings, not just contributions, from your Roth IRA before age 59 1/2 still incur taxes and a 10% penalty, even with exceptions like disability or education expenses.
Traditional IRAs offer different tax advantages. Your contributions lower your taxable income for the year you make them, which can be a big benefit. But remember, early withdrawals before age 59 1/2 mean paying taxes plus a 10% penalty on the amount you take out (though, again, there are exceptions like first-time home purchases). This means while Roth IRAs offer more flexibility for early access to your contributions, Traditional IRAs can potentially save you more in taxes depending on your income bracket and retirement plans.
You can contribute to both Traditional and Roth IRAs to leverage the benefits of each. The combined contribution limit for both types in 2024 is $7,000, with an increased limit of $8,000 for individuals aged 50 or older. Whether you max out or not, contributing regularly is key to securing a comfortable retirement. Remember, the power of compounding interest over time is your best friend in the long run.