Have you ever wondered what is the difference between a Roth IRA and a Traditional IRA? You would not have been the first person to ask. They can both be effective tools for helping people save money for retirement, but they do have different characteristics. One plan is better for people that are looking to lower their taxable base now and the other is better for people that are looking to lower their taxable base later. Let’s take a look at the difference between Roth IRA’s and Traditional IRA’s.
Traditional IRA’s are tax deferred plans that allow you to make contributions from your pretax income. This has the effect of lowering your taxable income and allowing you to gain tax free growth. Traditional IRA account holders pay less in taxes today based on the hope of taxes being at a much lower rate in the future.
In order to qualify for a Traditional IRA, you have to meet two criteria. First, you must be under the age of 70 ½. Secondly, you must have some documented form of compensation. Contributions are maxed at $5,000 for anyone under the age of 50 or $6,000 for anybody 50 and over.
Since Traditional IRA account holders do not pay taxes on their contributions, they do have to pay taxes on their withdrawals. Account holders are required to start taking minimum distributions on their funds by the age of 70 ½. All withdrawals are subject to the income tax rates of the time they are taken out.
Roth IRA’s are tax advantaged plans in which you forego a tax deduction today in order to withdraw your money tax free down the road. All contributions are made from after tax income. In general, Roth IRA account holders prefer to pay their taxes today since they believe that tax rates will be higher in the future.
In order to participate in a Roth IRA, you just need to have some documented form of compensation. This can be in the form of wages, tips, or even alimony. Just like with a Traditional IRA, you can contribute up to $5,000 a year if you are below the age of 50 or $6,000 annually if you are older than 50.
Main Difference between Roth IRA and Traditional IRA
One big difference between Roth IRA’s and Traditional IRA’s are that all earnings and contributions taken after the age of 59 ½ are income tax free with a Roth IRA.
Also, with a Roth IRA, you can take out your own contributions penalty-free at any time. For example, if you contributed $5,000 a year for 3 years and had $16,500 total when a big emergency hit, you could withdraw up to $15,000 penalty-free. The trick is that you can’t pay yourself back though after making an early withdrawal.
Finally, there are no required distributions for Roth IRA’s.
I personally contribute to my 401(k) and a Roth IRA. In fact, my husband fully funds a Roth IRA too. We figure that diversity is a good thing in most aspects of life – especially when saving for retirement.
Do you contribute to a Traditional IRA or a Roth IRA? What do you think about them?
Crystal Stemberger uses Budgeting in the Fun Stuff to write about finding the balance between paying your bills, saving for your future, and budgeting in the fun stuff along the way.