An individual retirement account can help you save for retirement while enjoying some tax breaks. But which type of IRA is best?
Both traditional and Roth IRAs have significant tax advantages, but in some situations, one may be better than the other. Considering the pros and cons of each can help you decide which one could offer the most tax benefit when it's time to retire.
Here's how the two compare.
How Traditional IRAs Work
A traditional IRA is a type of individual retirement that allows for pre-tax contributions. These contributions may be tax-deductible, depending on your income, filing status, and whether you're covered by a retirement plan at work. Your money grows tax-deferred and you can begin making withdrawals at age 59½.
Those withdrawals are taxed at your ordinary income tax rate. Once you reach age 72, you must begin taking required minimum distributions each year. These distributions are based on your account balance, age, and life expectancy, and they could affect your final tax bill for the year.
For 2021, you can contribute up to $6,000 to a traditional IRA, along with an additional catch-up contribution of $1,000 if you're 50 or older. If you expect to be in a lower tax bracket when you retire, you could see the greatest tax benefit from a traditional IRA, versus a Roth.
How a Roth IRA Works
You can think of a Roth IRA as the opposite of a traditional IRA in terms of taxation.
With a Roth IRA, your contributions are made on an after-tax basis, which means there is no current tax benefit to you when you make a contribution. In other words, you don't get a deduction for contributions.
However, you will benefit on the other end since qualified distributions from a Roth IRA are 100% tax-free. This typically benefits those who expect to be in a higher tax bracket upon retirement. Contribution limits to a Roth IRA are the same as they are to a traditional IRA: $6,000, and if you're 50 or older, $7,000.
Additionally, Roth IRAs do not require that you take required distributions upon reaching age 70½. This can be increasingly important as people are living and working longer.
Just keep in mind that there are income limitations that may prohibit higher-income individuals to participate in a Roth. If you make too much money to contribute to a Roth, you'll have to choose a traditional IRA instead.
Ask Yourself These Questions
As you weigh the pros and cons of the traditional and Roth IRA, here are some questions that may ask yourself or discuss with your financial advisor.
- Do you expect your income to increase or decrease in retirement?
- Do you expect your tax rate to be higher or lower when you retire?
- What is your current tax bracket?
- How much income do you need on a monthly basis once you retire?
- How long do you plan to work?
- Do you expect to pass on your IRA to someone else when you die?
Making a decision between a traditional and Roth IRA may be difficult if you're eligible to contribute to both for retirement. Again, it all comes down to whether you're more comfortable being taxed now versus being taxed later.
You may also make considerations on what will work best for you based on income limits, contribution limits, tax incentives, withdrawal rules, and future tax rates. And look into your workplace retirement plan options. If you want to hedge your bets, you may want to consider a traditional IRA and contributions to a Roth 401(k). This would allow you to max out annual contribution limits to both plans while getting dual tax benefits.
If you're confused about the benefits of a traditional or Roth IRA, or you're just unsure how to proceed, it's always a good idea to speak with a qualified financial planner before making a decision. You can also visit the IRS website for additional information.