Individual Retirement Account (IRA): Roth vs. Traditional

All of us must plan for retirement. In order to do so, you can utilize tax-advantaged accounts, such as an individual retirement account (IRA), Roth IRA, or 401(k). This article will focus on IRAs, which are individually funded by you, whereas a 401(k) will be through your employer and often receives contributions from both the employee and employer. Regardless of your age, it is important to understand how retirement accounts work and contribute to them consistently until you reach your retirement goals.

Traditional IRA vs. Roth IRA

Both a traditional IRA and Roth IRA provide substantial tax benefits and allow you to grow your retirement nest egg much more rapidly than a traditional brokerage account with no tax benefits. A traditional IRA is funded from your money prior to it being taxed. In other words, if you contribute $1,000 to the account, you will not pay taxes on that $1,000 now. Rather, when you start withdrawing funds from the traditional IRA, you will pay taxes on your initial contributions and any growth or interest earned. Alternatively, a Roth IRA is funded with money that has already been taxed. For example, say you earn $1,000 and want to contribute it to your Roth IRA. If your taxes are 15%, then you will have $850 remaining to contribute to the account. Thus, you pay taxes now, but when you withdrawal the funds, any growth on the account is tax free. If that $850 grows to $6,800 over a 20-year period, you will not pay any tax on the $5,950 of profit. Remember, you already paid taxes on $850, so no additional tax will be levied on that amount either.

Is a traditional IRA or roth IRA better?

In the long run, either account will provide substantial benefits. If you open a traditional IRA, you will have more money upfront to fund the account, which means you will be investing more money early, giving it more time to grow. However, future tax rates are unpredictable, so there is no way to know what tax bracket you will fall in when you retire. On the other hand, you will not have to worry about taxes later on with a Roth IRA, but the amount you invest now is smaller because you have to deduct taxes before investing. Therefore, the amount invested is smaller, so you can expect the growth to be less. If you plug in your current age, annual contributions, retirement age, and expected return rate into an IRA comparison calculator, a Roth IRA will typically provide slightly higher returns, but the difference is not substantial. However, due to the unpredictability of future tax rates, my recommendation is a Roth IRA. However, in order to contribute to a Roth IRA, you must earn less than the income limits set for a Roth IRA. If you earn above this amount, then you will be limited to making traditional IRA contributions.

Age to Withdraw from IRA

Because the intent of an IRA is retirement, the Internal Revenue Service (IRS) imposes age restrictions on accessing the funds. You will not be able to withdrawal funds from your account without penalty until your reach the age of 59.5 years old. If you withdrawal before this time, you will be subject to a penalty. There are some exceptions that allow funds to be removed before this age, but plan to not have access until you are 59.5. Additionally, you must start taking distributions from the account when you reach 72 years old.

Maximum Contribution Limits

As of 2023, the maximum amount you can contribute to an IRA is $6,500 if you are less than 50 years old. If you are 50 or older, then you can take advantage of catch-up contributions, which allow for an extra $1,000 annually, or $7,500 total. It is always best to contribute as early as possible to a retirement account, but the next best time to contribute is now. You cannot change the past, but maximize the advantage of a tax-advantaged IRA by contributing as much as possible.

Types of IRA Investments

Once you fund your IRA, you will have the option to purchase a wide variety of investment types, such as stocks, bonds, and mutual funds. If you want to pick individual stocks, then you can do so. Alternatively, if you want to have a professionally-managed mutual fund, you can select that as well. The first step is contributing to the IRA. After you make contributions, you then have to decide on an investment. If you want to know more about investing, check out our article on “Buying Stock” or our “Mutual Funds” article.

Conclusion

Both a traditional IRA and Roth IRA are great tools to invest in your retirement. They allow you to invest and benefit from tax advantages. While I typically recommend a Roth IRA because it typically has slightly higher returns over a several decade period, there are income caps in order to be eligible to contribute to a Roth IRA. If you exceed this maximum income amount, then a traditional IRA is a great option. Contributions will be accessible to you starting at age 59.5, and you will be required to start taking distributions at age 72. Once the IRA is funded, you will then have to decide what to invest those funds in.