Traditional IRA Versus Roth IRA
Many investors ask the common question of whether a Traditional IRA or a Roth IRA fits their needs best. While each account has its pros and cons, they're both great ways to save for your golden years. Some say that a Roth IRA is the closest thing to a perfect tax shelter you're probably ever going to find because you can accumulate assets in the account with no requirement to ever withdraw them.
Whether or not this matters to you, understanding the differences between the two accounts will make your choice easier. Examine both the Traditional IRA and the Roth IRA so you can get a better idea of how IRAs work and how each one might fit within your overall portfolio.
Accounts, Not Investments
Think of both the Traditional IRA and the Roth IRA as a type of holding account. Many different assets can go inside of it, from stocks, bonds, real estate, mutual funds, and index funds, to money markets and certificates of deposit, but it's such a good deal, Congress limits the amount of money you can put into that account every year. This is known as a contribution limit. Depending on which type of IRA you select, the tax consequences will be different.
An Overview of the Traditional IRA
Contributions are tax-deductible at the time they are made for individuals and families earning less than the income limitations in effect for any given year, which is regularly updated by the IRS. The contribution limits consist of a "base" contribution limit and a "catch-up" contribution limit that people 50 years or older can take advantage of. For example, in 2017, the base contribution limit was $5,500 and the catch-up contribution limit was $1,000, so a person who was 52 years old, and otherwise qualified for a Traditional IRA, could contribute $6,500 to his or her account.
For the years in which your money is sitting in your Traditional IRA, as long as you follow the rules, you won't owe any taxes on any of the investment profits you generate. That means no taxes on capital gains and no taxes on dividends, interest, and rents. Even if you find yourself sitting on millions upon millions of dollars in profits, as long as it is within the protective confines of the account, the Federal, state, and local governments get none of it. You'll only pay taxes on the growth once you withdraw the funds.
You can begin making withdrawals from your Traditional IRA at the age of 59.5 years old without having to pay the early withdrawal penalty. You must begin taking withdrawals and paying tax on those withdrawals. All withdrawals are taxed, including past contributed principal since it was tax-deductible at the time the contribution was made, by the age of 70.5 years old so you can't accumulate too much money in the tax shelter.
Traditional IRAs and Roth IRAs are extremely useful asset protection tools. Under the present three-year bankruptcy protection limit set on April 1, 2016, which is adjusted for cost of living every three years, an investor can have up to $1,283,025 in combined balances across both types of IRAs and have it exempted from creditor claims. Married couples can double this amount since both the Traditional IRA and Roth IRA must be owned by an individual. There's no such thing as a jointly owned IRA. This is one of the major reasons it is prudent to seek the counsel of a qualified bankruptcy attorney prior to any serious decisions when you are facing financial hardship. The worst thing you can do is draw down your Traditional IRA or Roth IRA balance then declare bankruptcy, as you've cost yourself years of rebuilding when you could have emerged from the courthouse with your retirement funds intact.
An Overview of the Roth IRA
Contributions to a Roth IRA are made with after-tax dollars and aren't tax deductible at the time they are made. However, unlike a Traditional IRA and subject to certain minimal conditions, if you need to make a withdrawal of your past principal contributions, you can do so tax-free without an early withdrawal penalty, though you won't be able to replace the funds once they've left the account. There are tax consequences for any investment gains or other funds in excess of the historical contributions into the Roth IRA if taken before the age of 59.5 years old.
During the years the money is in the Roth IRA, any profits you generate will grow tax-free.
There is no mandatory distribution age. If you live to be 105 years old and end up with a $25,000,000 Roth IRA because you discovered the next McDonald's, you don't have to give a dime of it to Federal, state, and local governments if you made a withdrawal and began spending it under the present rules.
The same bankruptcy protections that cover the Traditional IRA also cover the Roth IRA.
The tax shelter benefits are so beneficial for a Roth IRA that Congress specifically limits it to individuals and families with adjusted gross incomes of less than certain pre-determined thresholds. These are updated every year.
To take advantage of the Roth IRA's tax benefits, many Americans who don't qualify because they make too much money engage in a technique called a "backdoor Roth IRA" that involves funding a Traditional IRA, then converting it to a Roth IRA.
How Can I Open an IRA Account?
A Roth IRA and a Traditional IRA are both types of accounts, not investments, so you can open either with many different types of financial institutions. If you go to a bank or credit union, they might offer either type of IRA but only allow you to put certificates of deposit into them.
If you own either IRA with a discount brokerage firm such as Charles Schwab or Scottrade, you can put almost anything that is publicly tradable into it, including exchange-traded index funds such as SPDRS or blue-chip stocks. Some investors who exclusively use mutual funds for their retirement needs prefer to open an IRA account directly with a mutual fund family such as Fidelity or Vanguard.
How Much Money Do I Need To Start?
The minimum opening balance for either type of IRA is determined by the financial institution with which you are opening the account. Some require $1,000 to $3,000. A few will allow you to start with as little as $100 on the condition that you deposit some minimum amount per month for a given period of time to demonstrate your savings commitment.
Can I Have Both Types?
Yes, and you can even add funds to both in the same year provided your total, combined contribution doesn't exceed the contribution limits in effect for the year. For example, in a year where a 37-year old can only contribute a total of $5,500, that person could put $2,000 in a Traditional IRA and $3,500 in a Roth IRA because combined, they are still at, or under, the $5,500 limit. If you exceed the contribution limits and don't remedy it within a certain window of time, the government will assess taxes that will essentially wipe out your surplus balance.
Can I Have a Roth IRA and/or Traditional IRA Plus a Retirement Account at Work?
Yes. Whether you have a W-2 job or work for yourself, you have many options for additional retirement accounts. In addition to funding a Roth IRA or Traditional IRA each year, you can also fund a Traditional 401(k), a Roth 401(k), a Solo 401(k), a 403(b), SEP-IRA, SIMPLE IRA, or other qualified plans. These often have other advantages of their own, including unlimited bankruptcy protection on top of the bankruptcy protection offered on the IRAs discussed.