The two most popular forms of the Individual Retirement Account (IRA) available to United States citizens are the traditional and Roth IRA. Each offers a tax advantaged way to save for retirement but go at it in two entirely different ways. Understanding the nuances of these plans can help you decide which version of the IRA best fits your retirement goals.
First, the traditional IRA allows you to invest money in your account on a pre-tax basis. That means that any funds you add to your IRA account are not subject to income tax – saving you the twenty to forty percent in taxes that would have normally been assessed on that money. The money then grows tax free until you reach retirement age (set at fifty-nine and a half years old) at which point any distributions are taxed as personal income.
There are a couple of important points regarding traditional IRA accounts that you should be aware of.
First, when you’re ready to receive distributions from your IRA account at retirement your tax bracket will likely be much lower than your tax bracket when you invest the money in your IRA. This means that even though you’re paying taxes on the distributions you’re saving the difference between your retirement tax rate and your working tax rate. That could mean a savings of ten to twenty percent in the amount of taxes you would owe on that income over the life of your IRA account.
Second, although the growth in your account isn’t taxed as it’s accrued it is taxed upon withdrawal. So, even though your tax rate may be lower in retirement providing you tax savings on your contributions, you’re still going to have to pay taxes on the growth of the investments in your account. You end up saving on the front end with the tax deferred contributions but every dollar invested and every dollar earned from those contributions ends up being taxed upon withdrawal.
With a Roth IRA, your contributions to the account are made with after tax dollars. In a thirty percent tax bracket, that means a $1,000 investment in a traditional IRA would only net a $700 investment in a Roth IRA. The important distinction here is that this contribution will then grow tax free and can be withdrawn tax free upon retirement. This means that, after the initial taxes paid on your contributions, you’re no longer taxed on that money or the growth in your Roth IRA account.
Certain income restrictions apply to a Roth IRA account that don’t apply to a traditional IRA account but, if you’re below that threshold (currently around $100,000 for single filers and $175,000 for married persons filing jointly), it’s clear that the Roth IRA offers the most tax advantages of the two account options.
Even though you have to pay taxes on the initial contribution (just as you would for any non-retirement investment account), all the growth of that contribution is free from taxes. Considering the fact that the bulk of the funds in your IRA account will be from the growth of, and interest paid on, your investments you’ll end up avoiding taxes on the majority of your retirement savings.
You’ll start off with a little less of your money going to funding your Roth IRA when compared to a traditional IRA but escaping taxes on every dollar of growth within that account from that day forward more than makes up for starting a little farther behind.