By Lee Sherman
When it comes to IRAs there are two basic types: traditional and Roth. The simplest difference is that a traditional IRA defers your tax liability until you withdraw from the account, while Roth IRAs take out your tax liability at the time of your investment. But don’t tune out yet, there are a lot of other things to know about how IRAs work.
With a traditional IRA, you contribute pre-tax earnings, lower your tax liability for that year and sit back and watch as that money grows on a tax-deferred basis year after year. With a Roth IRA, you pay taxes on the amount of your contribution upfront. Once you’ve paid those taxes, you don’t pay them again. That means you don’t pay taxes when you withdraw the money.
To see how this works, let’s do the math. For example, if you make $60,000 a year and contribute $1,000 to a traditional IRA, you are only taxed on the remaining $59,000. Even if you make trades or receive dividends from stocks, that income remains tax-free. It’s important to keep in mind however that once you start withdrawing money, it is considered income and you are taxed on the full amount of the withdrawals. In any case, keep in mind that once you reach 70 ½ years old, you are forced to withdraw money from the traditional IRA each year. This is known as a required minimal distribution (RMD).
The age you plan on retiring can have a significant impact on which type of IRA you choose. If you plan on retiring early and don’t expect to be receiving a regular income, you’ll probably want to consider a more aggressive approach to investment such as the Roth IRA (or fill out your portfolio with dividend earning stocks). The Roth IRA is the opposite of the traditional IRA in the sense that you don’t get any tax breaks in the year you make contributions. So, to use our previous example, let’s say you earned $60,000 and contributed $1,000. You’ll be taxed on the full amount you’ve earned that year (in this case $60,000). There is no required minimum distribution during your lifetime.
So which is better for you? If, like many people you are in a higher tax bracket now and expect to be in a lower tax bracket when you retire, financial planners usually recommend going for the traditional IRA. For a Roth IRA, it’s just the opposite. A Roth IRA can work wonders for people who have waited longer to start saving for retirement. The reasoning behind it assumes that taxes will go up and this way you will have the money to invest instead of having to pay the government. This means you won’t be hit with a huge tax burden when you do retire and provides an extra level of protection for your nest egg. In some cases, it makes sense for one spouse to have one kind of IRA while the other has another. Or for one person to have both. Remember to consult a financial planner as your specifics will drive the ultimate decision.
Lee Sherman is a contributing writer to www.myperfectfinancialadvisor.com, the premier matchmaker between investors and advisors. Lee is an experienced journalist and editor with over 30 years of expertise with a significant history of writing in the personal finance and technology arenas.