There are many reasons why people today are putting off retiring. Maybe they need to continue to work for health care benefits, or just enjoy working their lucrative job. One reason could be that they did not save enough for retirement. A common way of saving for retirement is using a Individual Retirement Account (IRA). There are different kinds of IRAs, two of them being a Traditional IRA and a Roth IRA. Here we will detail the differences between a Traditional and Roth IRA to help you decide which is best for you.
What is an Individual Retirement Account?
An IRA is a type of account that’s purpose is to help you save money for retirement. As mentioned earlier, there are different kinds of IRAs. For instance, there is a Traditional IRA, Roth IRA, SEP IRA, and a Self-Directed IRA, to name a few. This list is not exhaustive – there are even more.
This type of retirement account has tax advantages that allows you to save even more towards retirement. Each of the types of IRA have their own nuances. For the purpose of this article we will just detail the differences between a Traditional and Roth IRA.
Before we dive in, we should note that IRAs do have annual contribution limits. For instance, the maximum contribution to an IRA is $6,000 for those under the age of 50, and $7,000 for those 50 and older. Before you open an IRA, be sure to check with your accountant or the IRS website to see if these limits have changed.
An IRA is really only to be used for retirement savings. You should not think of an IRA as an emergency fund. If you have to withdraw money from your IRA and you are not a specific age, you can pay early withdrawal fees and will have to pay taxes.
IRAs Offer Tax Advantages
The main difference between an Traditional and Roth IRA are the tax incentives or advantages that come with them. The purpose of both of these types of retirement accounts is to incentive taxpayers to save for retirement. The tax savings can be substantial over a lifetime of savings. The difference between the two is the timing of the tax deductibility.
A traditional IRA is an individual retirement account that allows your earnings to grow tax deferred. With a traditional IRA, you can deposit pre-taxed dollars. You won’t pay taxes on investment income (interest and dividends) or capital gains until you make a distribution once you retire. When you do withdrawal, you are taxed at your ordinary income tax rate.
Contributions to a Roth IRA are made with post-taxed dollars. However the earnings in a Roth IRA can grow tax free. The tax benefit of a Roth IRA comes in retirement in the form of tax free distributions. Additionally, since contributions to a Roth IRA are after tax contributions the taxpayers can withdraw their contributions, not the earnings, tax free and penalty free.
What investments can you hold in an IRA?
The majority of the differences can be attributed to the tax advantages mentioned above. When it comes to what investments you can hold in an IRA, a Traditional and Roth IRA are pretty much the same.
Fortunately, you can hold many different types of investments in a IRA. Below is a list of some of them – by no means is this all of the investments you can hold in an IRA.
- Mutual Funds
- Exchange traded funds (ETF)
- Real estate
- Precious metals
If you have any questions regarding holding less traditional investments in your IRA, such as precious metals like gold, or cryptocurrencies like Bitcoin, reach out to your accountant. They will be able to provide you with more information.
If you are deciding to open an IRA, you should be aware of the types of investments that are strictly prohibited from being held in an IRA. Here are several assets and securities that you cannot hold in an IRA:
- Antiques and collectibles
- Life insurance policies
- Hedge funds
- Real estate for personal use
- Gold coins
While you can hold precious metals in an IRA, you cannot hold gold coins. Also, even though you can hold real estate in your IRA, this real estate cannot be for personal use.
Traditional and Roth IRA Differences – Summary
Individual Retirement Accounts, or IRAs, are a very useful tool. These type of accounts specifically created to help you save for retirement offer a ton of benefits. That being said, there are some differences between a Traditional and Roth IRA. These accounts are different when it comes to their tax incentives and advantages.
If you have further questions, feel free to leave a comment below. Your accountant or financial advisor should also be able to help you.