An IRA stands for Individual Retirement Account. IRAs are a way to save specifically for retirement. There are two main types of IRA accounts: a Traditional IRA and a Roth IRA. Both were created with the intent to help you fund a retirement savings that can earn interest over time. While the ultimate goal of the two accounts is the same, there are differences in how you contribute, withdraw, and pay taxes. Outlined below are the differences between Traditional IRAs and Roth IRAs in regards to the following topics.
Anyone who has earned income and is below the age of 70 ½ can contribute to a Traditional IRA. There are no income limits.
For a Roth IRA, there are income limits that depend on tax filing status. I fyou file your taxes as a single individual, you must have an income below $131,000 to be eligible to contribute. If you file jointly, you must have an aggregated income of less than $193,000 to qualify.
With a Traditional IRA, the money you contribute is pre-tax. Therefore, when you withdraw the money later on, you will have to pay taxes on the money you withdraw. The reason behind this method is that you might be in a lower tax bracket when you retire, and when you are withdrawing the money, than you are when you are working and contributing to your account. If this were the case, you would pay less money on taxes when you withdraw than if you were contributing after tax dollars as you worked, in that higher tax bracket. Any contributions you make to a Traditional IRA are tax deductible.
When you contribute to a Roth IRA, you are contributing after tax dollars. This means that the money you put into the account has already been taxed so when you withdraw it in the future, you will not have to pay any more taxes on it.
When you have a Traditional IRA account, you must start taking withdrawals when you reach age 70 ½. This is called a Required Minimum Distribution, or RMD. At age 59 ½, withdrawals are penalty free. If any money is withdrawn before age 59 ½, it can be subject to a 10% early withdrawal penalty charge.
There are no required minimum distributions if you have a Roth IRA. With this type of account, you are not required to take any withdrawals if you don’t need the money. You can keep the money in the account to grow tax deferred for your lifetime. If your beneficiary were to receive the money, they would not have to pay any income tax on the money*. Contributions to an IRA can be withdrawn at any time, tax-free and penalty free. Any earnings that you withdraw before age 59 ½, or within the first 5 years of opening the account will be subject to a 10% penalty.
These are important differences to keep in mind when thinking about starting an individual retirement account. Both have incentives for different circumstances and situations that you should consider when making a decisions. We suggest you speak with your financial advisor about your personal financial situation and goals to help determine the best route for you.
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*These are 2016 income limits and may change year to year.
**Beneficiaries may still be required to pay estate taxes.
Financial Sisterhood TM, 2016