Planning for retirement is no easy task. As an employee in the United States taking advantage of Individual Retirement Account or IRA is a smart addition to your retirement strategy.
However, how do you know which IRA is right for you? Should you be taking advantage of a Traditional IRA or a Roth IRA? Let’s look at some of the main differences between the Traditional and Roth IRA below.
The traditional IRA allows for tax-deferred growth. Withdrawals are usually penalty free but are limited to certain items including college expenses, purchase of our first home (this does have a lifetime cap of $10,000) some major medical expenses and can even include some unemployment expenses that are long term.
The Roth IRA, on the other hand, offers tax-free growth. However, withdrawals are only tax-free providing that you are over the age of 59 ½ and your Roth IRA has met the 5-year aging requirement. So long as these 2 requirements have been met then withdrawals from the Roth IRA are free from federal taxes.
Eligibility and Contributions
With the Roth IRA, you are eligible to contribute employment earnings at any age. The traditional IRA, however, does not allow for contribution beyond age 70 ½. Now keep in mind that the amount of income you make will influence your eligibility to open a Roth or Traditional IRA.
If you withdraw funds from your traditional IRA before age 59 ½ you likely will face a 10% early withdrawal penalty. However, keep in mind that you are allowed to withdraw funds if it is one of the allowed exceptions mentioned above. With the Roth IRA, early withdrawal that is not qualified will be taxed on earnings plus an additional 10% tax. But also remember that the Roth IRA does allow for qualified withdrawals to take care of things like buying your first home or to take care of death expenses for example.
So to clarify, with a Roth IRA you can take withdrawals no earlier than 5 years after you began to fund your original Roth IRA. You base this 5 year period starting with the year you made the first official contribution to that Roth IRA. So be careful and check this post about common mistakes to avoid.
The allowed distribution circumstances must meet one of the following:
You are age 59 1/2 or older.
You have become disabled in some way.
You are purchasing your first home but remember there is a $10,000 cap applied.
You have died and so now your spouse etc can now get distribution because you’ve died.
Minimum Required Distributions
With the Traditional IRA, the minimum required distributions must begin at age 70 ½. With the Roth IRA, there is no minimum required distribution as long as the original owner is still alive and controls the Roth IRA.
Both the Traditional and Roth IRA have a maximum contribution of $5000 for the last year (This is raised to $6,500 if you are age 50 or older though) or 100% of your employment earnings whichever happens to be less.
For both the Roth and Traditional IRA if you are age 50 or older you are allowed to contribute an additional $1,000 each year. This allows you to make up for passed missed contributions to your IRA plan. Be careful, though, when making early withdrawals from your 401k plan!
So given the above information what should you do when deciding on which route to take? Would it make more sense to opt for a traditional IRA or a Roth IRA?
Basically, you need to look at this from your current and future tax liability situation. Usually, the Roth IRA will make for a better option if you know y0ur tax rate during retirement will be higher than your current tax rate. This obviously means that you will be able to pay taxes now which will be much lower than when you retire. Also upon retirement, you then can start taking the tax-free distributions during the period when you know your tax rate will be higher. However, if you are certain that your tax rate will be lower during your retirement years then it makes sense to opt for the Traditional IRA. This is because you can take advantage of the tax deductions now during the time when your tax rate is higher.
There is one more thing to consider and that is what if you are eligible to take advantage of both a Traditional and a Roth IRA. See also this post on how to use your 401k plan to build up a nice real estate portfolio.
This is a very interesting position to be in and if you are able to you can indeed split your contributions between both IRA plans. However just keep in mind that you still must abide by the yearly contribution limits and that must include any catch-up amounts also.
The problem with splitting up your contributions between both the IRA plans is that you will face additional fees for doing so.
In the end, you are the only one that can make the final decision as to which IRA plan will be best for you. Choosing between a Traditional or Roth IRA requires you to study all the finer points of both plans and to take into consideration what your future tax situation will look like. Either way both IRA plans can be a solid part of your overall retirement plan and should be used as such.