An individual retirement account, or IRA, can be a highly effective way to save and invest for retirement. The tax-deferred nature of these accounts can allow your money to grow and compound far more efficiently than in a standard taxable brokerage account. There are two main types of IRAs to choose from: traditional and Roth.
With that in mind, here’s an in-depth look at the differences between the two main types of IRA, the qualifications for each one, and what you need to know about how these accounts work.
What is an IRA?
IRA stands for individual retirement account. An IRA is a savings vehicle designed to help Americans save and invest for retirement in a tax-advantaged manner.
For most people (self-employed individuals have a few more options), there are two types of IRAs available — traditional and Roth.
Both types of IRA have certain characteristics in common.
Specifically, investments held in an IRA are allowed to grow and compound without any tax implications for as long as they remain in the account.
For example, if you own a stock in your IRA and receive dividends, you won’t have to pay dividend tax each year. If you own bonds in your IRA, you won’t have to pay federal income tax on the interest you receive. And finally, if you sell investments in your IRA at a profit, you won’t be liable for paying capital gains tax as long as you don’t withdraw the money.
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The main difference between traditional and Roth IRAs is the way they are treated by the IRS, so that’s where we’ll start.
As I mentioned, both types of IRA allow your investments to grow and compound without income taxes as long as the money remains in the account. The main difference is how contributions are treated.
With a traditional IRA, qualifying contributions are eligible for a current-year tax deduction. In other words, if you qualify for the traditional IRA tax deduction (we’ll get into the qualifications later) and you contribute $2,000 to a traditional IRA for the 2018 tax year, you’ll be able to exclude this amount of money from your taxable income.
Traditional IRA funds are not taxed until they are withdrawn from the account. Your eventual traditional IRA withdrawals, regardless of when or why they are taken, will be considered taxable income.
Roth IRAs give you a tax break later
On the other hand, Roth IRA contributions are never deductible in the year they’re made. If you contribute to a Roth IRA for the 2018 tax year, that money will still be included in your taxable income.
Instead, the tax benefit of a Roth IRA comes later.
Qualified withdrawals from a Roth IRA are 100 percent tax-free To get this tax-free treatment, your Roth IRA must have been open for five years or more, and you must meet a qualifying withdrawal condition, such as reaching a minimum age.
We’ll get into the specifics of IRA withdrawals later, but the point is that Roth IRAs are designed to prepay your taxes now so you don’t have to pay tax on your Roth IRA income in retirement.
Roth IRAs have some other key advantages
Finally, there are no minimum distribution requirements from a Roth IRA as you get older.
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Traditional IRA account owners are required to start taking distributions after reaching 70 1/2 years of age. The idea is that traditional IRAs are tax-deferred accounts, and the IRS wants to start getting some tax eventually. Since Roth IRA withdrawals can be tax free, there’s no reason for the IRS to force account owners to take distributions.
IRA Contribution Limits
If you are under 50 in 2018, you can contribute as much as $5,500 to your IRA(s) for the 2018 tax year.
The IRS determines the IRA contribution limit each year. For the 2018 tax year, there are two different IRA contribution limits, depending on the age of the account owner.
If you are under 50 in 2018, you can contribute as much as $5,500 to your IRA(s) for the 2018 tax year.
If you are 50 or older in 2018, you can contribute as much as $6,500 to your IRA(s) for the 2018 tax year. The extra $1,000 is known as a “catch-up contribution.”
The timetable for IRA contributions is a little more flexible than the calendar year. Contributions for a specific tax year can be made any time between the first day of that calendar year and the regular tax deadline in the following April. This means that 2018 IRA contributions can be made anytime between January 1, 2018, and April 15, 2019.
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Another advantage: Roth IRA contributions — though not any investment gains — can be withdrawn at any time and for any reason. If you have contributed $5,000 to a Roth IRA each year for 20 years, then you can access $100,000 of your savings whenever you need to.
I don’t recommend withdrawing this money, but it is nice to know it is an option. Read why an emergency fund is so important here.
With a traditional IRA, you’re at the mercy or uncertainty of what future higher tax rates might do to your retirement savings. But With a Roth IRA, you don’t have to worry about future rates, because you wont have to pay tax on the withdrawals.
Check out the free retirement calculator at Marketwatch here.
Take it from me, the years will roll by faster than you can imagine. Contributing to a retirement account now is the best way to prepare for retirement.