Roth IRA or Traditional IRA? Which one is right for you?
At some point in your career your employer will ask whether you would like to make contributions to a retirement account. Initially, you think, “Sure. Where do I sign?” Yes, it can be that easy, but if you’re smart, you know there are choices.
You will see choices on the enrollment forms like “Roth IRA” or “Traditional IRA” followed by pages of words that all sound like a sales pitch. It’s at this point where you start to daydream and decide to keep your savings under your mattress. But assuming you can fight through the boredom of learning about retirement accounts, which investment vehicle really is best?
I hate saying this, but the truth is: It depends. It depends upon YOUR situation, not the type of investment vehicle. No single investment vehicle is right for everyone. There is no “one size fits all.” You’ve heard this before, but the best advice really is: Make an appointment with a qualified financial planner! Accept it. You’re not a financial expert. Few of us are and you know that your retirement is priority number one. Stop procrastinating and find a financial planner to discuss your needs, resources and goals. I did. I survived. I felt smarter afterwards too. No, it didn’t cost a fortune. In the end, it saved me money. Lots of it. But assuming you refuse, allow me to share what I learned about IRAs.
The basic differences between a Roth IRA and a Traditional IRA have to do with income limits for contributions, withdrawals and taxes (ugh). While I cannot go into detail here, I will highlight some key differences.
A Roth IRA has income limits for contributions whereas a Traditional IRA has none (no limits). The limits for maximum contribution change with tax law changes. For both 2013 and 2014, the maximum contribution for Roth IRAs and Traditional IRAs was $5,500 per year ($6,500 if you are 50 years old or older) or 100% of employment compensation, whichever amount is less. Contributions for both types of IRAs have to be made by April 15 the year after the tax year for which you are contributing. For example: all 2014 contributions must be made by April 15, 2015.
Although withdrawals in general are highly discouraged, both Roth IRAs and Traditional IRAs allow penalty-free withdrawals for certain situations. Some examples are: qualified higher education expenses, first time home purchases and certain major medical expenses. These certain situations may allow you to make a withdrawal before you are 59 ½ years old. Otherwise, those withdrawals are subject to a 10% penalty.
A Roth IRA has tax-free (growth on) earnings and tax-free withdrawals as long as the necessary requirements have been met. A Traditional IRA has tax-deferred (growth on) earnings and taxes are paid upon withdrawal. Do you think your personal tax rate will be higher or lower when you retire compared to where it is today? If higher, then you may consider the Roth IRA because your taxes on withdrawals would be at a higher rate – and all gains over time are tax-free. If lower, then you may consider the Traditional IRA because your taxes on withdrawals would be at a lower tax rate. Or you can open both types of accounts and hedge your bets!
Withdrawals, contributions, and taxes are just some of the differences between the types of IRAs. We haven’t even discussed 401(k)’s. So again, it is ALWAYS best to meet with a qualified financial plannerto ensure you are making the correct decisions for YOUR goals and YOUR income level. Most CPAs can make a recommendation for a qualified financial planner. Make the call.