It’s difficult to know exactly what the best course of action is when planning for retirement. This includes choosing the right retirement account for you and your needs. What is the difference between a Roth IRA and a traditional IRA?
Here’s what you need to know. Luckily, it basically comes down to one integral question.
What Do You Think Your Tax Rate Will Be In The Future?
If you can answer this question, then you’re well on your way to deciding which retirement account is best for you. That’s because the biggest difference between a Roth IRA and a traditional IRA is simply when you receive your tax benefit.
With a traditional IRA, you can start claiming and receiving a tax benefit on your returns right away. Every year you contribute to your traditional IRA, you can claim that contribution on your taxes and increase your refund. That means, however, that when you withdraw from the account in retirement, you will have to claim that money as income on your tax returns at that time.
The Roth IRA is basically the opposite for tax purposes. You won’t be able to claim contributions you make into your Roth IRA on your taxes now, so you won’t get any tax benefit in the immediate future. However, when you withdraw from the account in retirement, you will not have to pay taxes on that money. For tax purposes, it is not considered income (you already paid taxes on it).
So, it comes down to a question of now or later. If you think your tax rates will increase in the future, then it makes sense to contribute to a Roth IRA account. If you anticipate lower rates in retirement, a traditional IRA may make more sense.
What If You Don’t Know?
It can be difficult to anticipate your tax rates in retirement. There are other factors to consider between the accounts.
Overall, a Roth IRA is a much more flexible account. This includes rules around withdrawals and when you have had to start taking distributions in retirement. Because you don’t receive a tax benefit on a Roth IRA until retirement, there are no penalties from withdrawing money from the account (that is, if you need to withdraw early). With a traditional IRA, on the other hand, you’ll need to income tax on the money you withdraw as well as a 10 percent early withdrawal penalty from the IRS.
On the other end of things, the Roth IRA is still a bit more flexible when you enter retirement. That’s because you’re actually required to start taking distributions from a traditional IRA account at the age of 70 and a half, regardless of whether you want to or not. The Roth IRA has no such requirement, so you can let your money sit and continue accruing interest as long as you need.
The Final Verdict
The retirement account that’s best for you basically depends on when you want to receive a tax benefit. If a tax benefit can really help you now, then it’s perfectly reasonable to choose a traditional IRA account. However, the advantage of not taking it now is that you’ll have more money saved in a Roth IRA for retirement by default, because that’s when you’ll receive the tax benefit for that account. This forces you to save more for later by default, which can be a beneficial discipline system for many people.