An IRA (Individual Retirement Accounts) refers to several types of accounts an employee may set up during their working life in order to save money for when they retire. The attractive thing about these products is that they allow people to save money while also avoiding certain taxes. There are two main IRA products: Traditional IRA and Roth IRA. It is important to know how they work, what they have to offer and the specific characteristics of each one. That being said, and before going into detail on each IRA, the main difference between a Traditional and a Roth IRA is when an employee pays taxes on their IRA savings.
When Are Taxes Paid on Each IRA?
With a Traditional IRA, taxes are paid only when funds are withdrawn from the account. This means that money goes straight from the gross payroll (before the government takes it’s cut) and into the IRA, where it will grow tax-free until it is withdrawn. However there is a condition to this tax-free growth: the money must be withdrawn after the employee is 70 ½ years old and no extra money can be added after retirement. For qualified expenses, you may withdraw up to $10,000 after the age of 59 ½ and not incur the 10% withdraw penalty, however you must still pay taxes on the distribution.
Under a Roth IRA, savings are funded with after-taxed money. These funds grow tax-free and can be withdrawn without cost or fees after the account holder reaches 59 ½ years old if the first contribution to the account has been at least 5 years prior. Additionally, with a Roth IRA, you can continue to make contributions no matter how old you are. There is no obligation to withdraw money after a certain age, however, early withdrawals before the age of 59 ½ are taxed with a 10% penalty fee.
What Is the Best IRA Option?
That’s can be a difficult question to answer. To understand your options accurately you need to review many factors such as such as your current and expected earnings and age. It is important to note that not everyone is entitled to a Roth IRA. Qualifying for a Roth IRA depends on annual earnings, as there are limits that might disqualify you from adding tax-free money to a savings account.
However, the Traditional IRA might not be suitable for someone who is currently earning a low salary, as savings will be taxed after retirement, or whenever withdrawn, at the then current tax rate (i.e. the tax rate when you retire or withdraw your IRA savings), which could be significantly higher after a few years.
There is still another factor to take into account when considering an IRA: the penalties for early withdrawals. Many people decide to use, at some point, savings from their IRA in order to buy a new house or pay for college tuition, instead of saving the money for it’s intended use as retirement savings. Early withdrawal fees may apply, and in most cases this means money is taken away from savers. For those who foresee the need to use money from their IRA, a Roth IRA would be more helpful as more flexibility may benefit employees.
Either a Traditional or a Roth IRA is an interesting way of saving money without losing a ridiculous amount on taxes. The advantages and disadvantages of each model will be dependent on the employee’s personal and professional circumstances. Whatever the case, the Traditional IRA and Roth IRA are two major savings products that have changed how millions of people have been saving for decades.