Nearly half of American workers begin saving for retirement by the time they’re 30. Even those who haven’t begun have usually heard a few terms tossed around, including “401k”, “IRA,” and “trust.” When you’re first getting started, the amount of information available can be overwhelming. Some people even get so overwhelmed that they choose the first option that’s presented to them and neglect to investigate whether or not there are better options available. If you’re seeking the best way to prepare for retirement, then now is the perfect time to learn the difference between two common and effective retirement tools: the traditional IRA and the Roth IRA.
How a Traditional IRA Works
For many early investors for retirement, the traditional IRA is the “default” option. It can be set up in cooperation with your employer or through financial firms such as Fidelity. This kind of account allows you to contribute funds up to the current annual limit, which you can then invest in stocks and bonds. You can either control where your funds go or rely on a group strategy, such as assigning it to the financial firm’s retirement packages, which will manage the money for you.
Over the years, your annual contribution limit will tend to increase, and your investments may also appreciate over time. Therefore, the money you invest early on can grow with the stock market’s performance according to how effective your investments are. Even though you will likely be able to contribute larger amounts later on, the earlier you put your money to use, the greater the return you may see as a result.
One of the positive aspects of a traditional IRA is that your contributions are tax-deductible, allowing you to pay less in tax in the current year despite saving up for retirement. Although you’ll have less money in your pocket, it’s a good way to invest without having to pay extra taxes on the opportunity.
Although you can withdraw money from an IRA at any point, you will incur a 10% penalty if you do so before age 59 1/2. Also, once you turn 72, you will need to begin withdrawing from your traditional IRA, regardless of whether you have retired by that point. When you withdraw money from the account, it is taxed as regular income, even if your investments have appreciated significantly. Therefore, you can make money on the stock market without paying capital gains taxes.
The Unique Benefits of a Roth IRA
If you have a basic understanding of how a traditional IRA works, then you understand most of the mechanics of a Roth IRA, as well. The main difference and unique benefit of a Roth IRA are that you are contributing to the IRA with funds that are not tax-deductible. While that does mean you pay a little more upfront, the tradeoff is that you are no longer liable for any income tax on the funds you withdraw from the IRA after the age of 59 1/2. Additionally, Roth IRAs offer you the flexibility to avoid withdrawing from the fund if you don’t need to, meaning that you can keep the fund intact even past the age of 72.
Comparing Apples and Oranges
There are many similarities between the two, so it’s best to get a sense of how they compare using numbers. If you invest $10k in a traditional IRA, you will avoid paying taxes on that $10k during your working years. If the fund appreciates to $20k by the time you retire, you will end up paying taxes on that full $20k as you withdraw it. By contrast, investing the same $10k in a Roth IRA will cause you to pay the taxes during your working life, but you may withdraw the $20k during retirement without paying any income taxes on the funds.
|Contributions are tax-deductible on the current year
|Contributions must be made from post-tax income
|Withdrawals upon maturity are taxed as regular income, not capital gains
|Withdrawals are tax-free upon maturity
|Must begin making regular withdrawals at age 72
|No required withdrawals
Because annual contribution limits are for all kinds of IRAs, you should consider carefully what kind of investments you intend to make. In 2023, the individual contribution limit will be $6,500 per year for those under 50 and $7,500 for those over 50. Based on historical data, Roth IRAs tend to have a better return overall, as inflation and economic activity have consistently driven up the value of the investments within an IRA’s portfolio. There’s nothing guaranteed in life, but between the two, Roth IRAs tend to serve prudent investors better in the long run.