First, allow us to explain what an IRA account is exactly. IRA stands for Individual Retirement Account, and you can have multiple kinds. The most popular retirement accounts are traditional accounts and Roth accounts. Both are accounts that you can open up at any time, usually with a certain starting deposit. You can contribute money to either account whenever you want, with a limit of $5,500 per year up until 50 years of age and a limit of $6,500 per year once you turn 50. The years after you turn 50 and up until you retire are often termed the “catch up contribution” years because of the ability to deposit an additional $1,000 during these years.
Now that we have defined an IRA, allow us to draw an illustration to better explain the differences between these two types of individual retirement accounts.
Imagine that you have just retired, and you are finally able to access the money in your retirement account that you’ve worked hard to maintain for the past several decades. Suppose you are planning your very first “go-go years” vacation and your calculations show that the trip is going to cost you approximately $10,000. Naturally, you want to fund the vacation with the hard-earned savings in your retirement account. If your savings are held in a Roth IRA, then you can withdraw $10k from your account and be on your way to that nice vacation. However, if your retirement savings are held in a traditional IRA, your vacation is now going to cost you more than $10k. Why is this? Here’s why: tax consequences.
Traditional IRA
Once you turn 59 ½ years of age, you can access the money in your traditional IRA. If you want to withdraw money from your account before you turn 59 ½— say you need money for an unexpected emergency—then you are required to pay a 10% penalty fee on the amount that you wish to withdraw. After you turn 59 ½, your withdrawals are no longer penalized, but they are taxed. This is why your $10,000 withdrawal for your vacation is actually going to cost you more, because your $10k withdrawal is taxed at your respective bracket. Everything you take out of your traditional IRA is taxed, no matter how old you are.
Once you turn 70 ½, you are required to take out a minimum withdrawal from your traditional IRA, called required minimum distributions. If you pass away before your retirement, the money can be transferred to a loved one, but this transaction will also be taxed.
Roth IRA
Roth account withdrawals are tax free as long as your Roth account has been open for at least 5 years and you are at least 59 ½ years old. Early withdrawals from a Roth IRA can be taxed, however. If you transfer your Roth account to a loved one, that transaction is also completely tax free.
At this point, one may ask why anyone would ever choose to invest in a traditional IRA over a Roth IRA. The reason a lot of investors choose a traditional IRA is because they receive tax deductions for funding a traditional IRA. If you have a Roth IRA, you don’t receive these tax deductions.
Essentially, the question you have to ask yourself when considering which retirement account to invest in is this: “Would I be in a higher tax bracket now, or in retirement?” we recommend consulting your tax advisor for a full evaluation of your tax situation and for the appropriate and professional advice concerning what plan is best for you and your family.