Credit: Shutterstock photoThere are many different methods and vehicles you can use to help save for retirement, and much of it boils down to your own agenda and goals. However, the vehicles you can use to achieve these goals have stayed relatively the same. The most popular ones include a 401(k) plan, Roth 401(k), traditional brokerage account, traditional IRA account and Roth IRA account.
While many people may have heard of traditional IRAs and Roth IRAs, the difference between the two may not be clear. It's important to understand their differences and how each can benefit your current financial situation.
Differences Between Roth IRAs and Traditional IRAs
Before diving into topics of eligibility, required minimum distributions (RMDs) and more, let us review the difference between a traditional IRA and a Roth IRA.
A traditional IRA is a vehicle in which you can grow your hard-earned money to assist in saving for retirement. With a traditional IRA, you can deduct your contributions at the end of the year. Your wealth will grow tax-deferred until you begin taking distributions, which will be taxed at your income level at the time of distribution, and you will be required to take minimum distributions (RMDs) once you reach retirement age.
With a Roth IRA, you use after-tax dollars to invest. However, when you withdraw your funds during retirement, you will not pay taxes. Also, your wealth will be appreciating tax-free in your Roth IRA account. Contribution limits are the same as a traditional IRA. Lastly, there are no RMDs like there are with traditional IRAs.
Tax Deductions and Contribution Limits
You can have a traditional or Roth IRA if you have a 401(k) or other retirement plan, but there can be tax consequences depending on your current financial situation and the active participant rule. An active participant is someone who receives benefits under an employer-sponsored retirement plan or participates in a retirement plan. Qualified plans include 401(k) plans, defined benefit plans, money purchase pension plans, SEP IRAs or SIMPLE IRAs. Utilizing one of these plans can impact your ability to claim a tax deduction for contributions made to a traditional IRA.
According to RetirementDictionary, “you are eligible to take full deduction for your traditional IRA contribution if you are not an active participant, or married to an active participant. On the other hard, if you are an active participant or married to an active participant, your eligibility for deducting a traditional IRA contribution depends on your modified adjusted gross income and tax filing status.”
You should also consider the contribution limits when deciding if an IRA is right for you. For 2018, if you are under 50 years of age, your limit is $5,500, and if you are over the age of 50, you can contribute $6,500. However, if you make too much money you are ineligible to contribute to an IRA. Fidelity Investments provides a chart to help you determine your contribution limits.
Withdrawal Limitations
As with most retirement accounts, there are consequences for early withdrawals.
With a traditional IRA, there is a 10% penalty in addition to regular taxes owed for withdrawing funds before age 59.5 unless they are used for a first time home purchase, medical expenses that are unreimbursed, or certain college expenses. After age 59.5, you can withdraw the funds without the penalty, and you will be required to take minimum distributions after age 70.5.
With a Roth IRA, the withdrawal rules are slightly different. Similar to a traditional IRA, if you withdraw funds before age 59.5, you will be subject to a penalty unless it is being used for a medical expense, first time home purchase or college,. However if your Roth IRA has been open for less than five years, you may be subject to penalties and taxes on the earnings as well. After age 59.5, if your Roth IRA has been open more than five years, you can withdraw your funds without penalty or tax implications, and there are no RMDs since this money was contributed after-tax.
Should you find yourself with a traditional IRA and are now wanting a Roth IRA, there may be the possibility of converting it into a Roth. Also known as a backdoor Roth IRA, you will have to pay income taxes on the contributions made to the traditional IRA. When doing so, ensure it fits your financial situation, because transitioning could push you into a higher tax bracket for that tax year.
Every individual has different investment objectives and retirement goals, and each vehicle fits different needs better. Carefully review your personal situation to determine which, if any, IRA is a good fit for you.
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This article was originally published on Investopedia.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
