Nowadays, many companies give you the option to choose between a Traditional IRA or a ROTH IRA. However, these same companies rarely tell you the advantages and disadvantages of choosing which retirement account is in each individual’s best interest.
BTW, IRA simply stands for an Individual Retirement Arrangement.
Traditional IRAs And ROTH IRAs Have Numerous Similarities
Both a Roth IRA and a Traditional IRA have many aspects in common.
1) To begin, contributions can be invested within investments such as common stocks, bonds, certificate of deposits (CDs), mutual funds, and/or an individual retirement annuity, a contract purchased from a life insurance company.
2) The contribution limits are the same amount; for year 2014, you can contribute up to $5,500 to your IRA, plus an additional $1,000 catch-up contribution if you reached age 50 or older by the end of the tax year.
3) Earnings made through capital gains, dividends, and/or interest within either IRA grow tax deferred; however, an important difference is with a Traditional IRA you are taxed when you withdraw earnings, while with a ROTH IRA you are not taxed upon withdrawal for these investment earnings.
4) Unfortunately, It is prohibited to take a loan out against a Traditional IRA and/or a ROTH IRA.
Advantages & Disadvantages of a Roth IRA
Benefits of a Roth IRA include fewer withdrawal restrictions and requirements. In contrast to a traditional IRA, contributions to a Roth IRA are not tax deducted; however, withdrawals are generally tax-free, depending on certain stipulations. For instance, any capital gains, dividends, and/or interest gained from the original investment can be withdrawn tax and penalty free after you reach age 59 1/2.
Unlike other tax-deferred retirement plans, with a Roth IRA you are taxed when you put money into the account and you gain the tax break when the money is withdrawn from the plan during retirement. This is beneficial because when you retire you have a better understanding of how much money you truly have since you will no longer have to pay taxes on your contributions, based on certain stipulations.
However, the disadvantage of being taxed upfront is, you may be in a higher tax bracket at that time, therefore you would be taxed at a higher rate. Basically, these contributions do not reduce your adjusted gross income (AGI), which may make you eligible for further tax breaks if you were able to drop a tax bracket.
Unfortunately, the largest drawback for a Roth IRA is the income limit which may affect future contributions. This chart from Edward Jones helps break down the income limitations:
Advantages & Disadvantages of a Traditional IRA
Traditional IRAs have been available to Americans since 1975 but in recent years has been losing ground to the newer Roth IRA. Contributions are tax exempt but when you begin withdrawing money in the future, these withdrawals will be subject to income tax. Contributions made to a Traditional IRA are tax deductible along with the growth within the account, i.e. capital gains, dividends, and/or interest. You can begin making withdrawals without being penalized by the age of 59 1/2. Since a Traditional IRA is tax deferred, when you begin making withdrawals you will be subject to income tax from these withdrawals. You can transfer a Traditional IRA into a Roth IRA with no fees or penalties, which may be beneficial within certain years for further tax breaks (This financially savvy move has numerous articles on when it is best to transfer accounts online but for this article’s purpose we will not get into those details).
Some restrictions within a Traditional IRA include paying a 10% early withdrawal fee if you take money out before you hit the age of 59 1/2. The only exception to this rule is if you are first time home purchaser you can withdraw up to $10,000 yearly, higher education expenses, death, disability, un-reimbursed medical expenses, health insurance, and annuity payments. Also, if you do not begin withdrawing money by age 70 1/2, you are subject to give up half of the mandatory amount to the IRS.
To recap, the main difference between a Traditional IRA and a ROTH IRA is that a Traditional IRA is taxed when you withdraw money, while you are taxed with a ROTH IRA when you add contributions to your retirement account.
Therefore, the main thing to consider when choosing a Traditional IRA compared to a Roth IRA is: whether or not you will be in a higher or lower tax bracket when you retire?
By Nader Saadawi: To contact Nader and learn more about investing and stock opportunities find him at @nadey14 or email him at firstname.lastname@example.org.