One of the questions that many savers face when deciding what type of account to open is that of Roth vs. Traditional. When trying to decide which type of retirement account is right for you, you need to consider your current situation, as well as try to realistically project what your situation will be like in the future, when you retire.
Roth vs. Traditional: The Difference is Taxes
The main difference between a Roth IRA and a traditional IRA is the tax situation. You can hold a fairly wide variety of investments in either type of IRA, and the same yearly contribution limits apply. There are some additional limitations, including the fact that your ability to contribute to a Roth IRA phases out as your income rises, but the biggest factor when deciding which type of IRA to invest in is taxes.
With the Traditional IRA, you pay taxes on your contributions later. You receive a tax deduction now, lowering your income so that your tax bill is smaller. A Traditional IRA is known as a tax-deferred account. You get the tax break now, and your money grows until you begin to withdraw the money during retirement. However, once you begin taking distributions from the account, you start paying taxes. Your withdrawals are considered income, and taxed accordingly.
The Roth IRA, on the other hand, operates a little differently. You make your contributions with after-tax dollars, so you don’t receive a tax benefit right now for using a Roth IRA. However, all your money grows tax-free. So, when you start taking withdrawals from the account, you don’t have to pay taxes on the money.
Those who choose the Roth IRA often do so in order to avoid what they think will be higher taxes when they retire. You give up the tax deduction now, but if your retire in a higher tax bracket, or if taxes rise before you retire, your potential tax savings could more than make up for it. And, even though those with certain incomes can’t contribute to a Roth account, it is possible for them to roll over money from a different retirement account. This “back door” Roth IRA contribution is becoming increasingly popular amongst those who would rather pay taxes now and avoid higher taxes later.
Other Consideration: Access to Funds
While comparing tax benefits is the main issue to be resolved when deciding between types of IRAs, there are some other considerations. With a Roth IRA, it is often a little bit easier to access your money even before age 59 1/2. With a Roth IRA, you can withdraw your contributions any time. As long as you aren’t dipping into your earnings, you can withdraw money from your Roth IRA without penalty, no matter your age.
It is generally considered foolish to dip into your funds like that, since the lost opportunity cost can be high over time, but if you need to access the money, it is easier to do without penalty.
As you consider which type of IRA makes sense for you, make sure you think about your future, as well as your current situation. Often, you do better to consider the future rather than fixate too much on the present.