Retirement Accounts: IRAs vs Roth IRAs

Saving and investing money in tax-advantaged retirement accounts is one of the most common and effective ways to prepare for retirement.

There are three different types of individual retirement accounts (IRAs)- traditional IRAs, Roth IRAs, and SEP IRAs.

At their core, they are all investment accounts that offer tax benefits in exchange for setting your money aside for retirement; the nature of these tax benefits are the key differentiators between each specific account.

Here are the basics on each type so that you can have a better idea of which one is the best choice for you.

Traditional IRAs give you a tax break now

A traditional IRA allows you to make pre tax contributions meaning you won’t pay any taxes on income you deposit that year. The flip side is you will have to pay taxes on any earnings you eventually withdraw from the account (deposits can be withdrawn tax-free).

You can contribute up to $6,000 per year to a traditional IRA ($7,000 if you’re 50 or older).

Roth IRAs give you a future tax break

Any income you deposit into a Roth IRA will still count as taxable earnings that year. However, you’ll be able to withdraw all your Roth IRA funds- deposits and earnings- tax free in retirement. By paying taxes on deposits, you’ll earn a tax break upon withdrawal.

Sep IRAs are designed for small business owners

Sep IRAs operate similarly to traditional IRAs, but they’re only available for small business owners and self-employed individuals. Just like a traditional IRA, contributions are tax-deductible in the year of deposit, and earnings are taxed upon withdrawal.

Choosing the right plan

Unless you’re self employed, you’ll be choosing between a traditional and a Roth IRA; the best choice is whichever maximizes your tax benefit. The answer to that question depends on how you expect your tax bracket to change over time.

If you expect your income to grow over time, meaning your tax bracket will increase as you get older, a Roth IRA is most likely a better choice because you’ll avoid the large tax penalty of withdrawing in a higher tax bracket.

If you expect to lower your tax bracket over time the opposite is true; you’re better off taking the tax break now and paying taxes later based on a decreased tax rate. In that case, a traditional IRA would be the right choice.

Keep in mind there are other differences like income restrictions and withdrawal mandates that set these accounts apart as well. Tax breaks are just the most significant difference which makes them important to understand first.

You can also open both a traditional and Roth IRA and balance your contributions between both; the most important thing is not which account you choose, just that you’re using at least one to save for retirement.

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