3 Key Differences Between Traditional and Roth IRAs You Need to Know | The Motley Fool

Staff
Staff
Oct 19, 2020 · 4 min read

There are such things as good and bad retirement accounts, but which is which often depends on your personal situation. Take traditional and Roth IRAs, for example. They’re similar in a lot of ways, but one of them is probably going to offer you better tax advantages than the other. Here’s a closer look at some of the key differences between the two accounts so you can decide which one deserves your money.

1. When you pay taxes on your money

The biggest difference between traditional and Roth IRAs is that traditional IRAs use pre-tax dollars, while Roth IRAs use after-tax dollars. That means traditional IRA contributions reduce your taxable income for the year, while you owe taxes on your Roth IRA contributions. But when it’s time to withdraw funds, things flip. You can take your Roth funds out tax-free, but the government demands a cut of your traditional IRA withdrawals.

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Both of them give you a tax break, so you might think you’ll come out about the same either way, but that’s not necessarily true. If you’re earning a lot of money right now, paying taxes this year might not make sense. You’re likely in a higher tax bracket, which means you’ll give more of your money back to the government. If you delay taxes until retirement, you’ll save yourself some money on taxes this year and possibly in the future. If your income is lower in retirement, you might end up in a lower tax bracket, helping you to hold onto more of your money.

But a Roth IRA could be better if you’re not earning a lot of money right now or you don’t believe your retirement spending will change significantly from your current income. In that case, paying taxes upfront is definitely the way to go, because you’ll only owe taxes on your contributions. Your earnings will grow tax-free.

2. Traditional IRAs have required minimum distributions

The government wants to make sure you withdraw your traditional IRA funds eventually so it can claim its cut. That’s why it institutes required minimum distributions (RMDs) for these accounts. RMDs begin at 70 1/2 if you reached this age before 2020, or at 72 if you’ll reach this age after 2020.

How much you need to withdraw depends on your age and your IRA balance. You can figure yours out by dividing your IRA balance by the distribution period listed next to your age in this table. If you had $100,000 in your IRA and you’re 72 this year, you’d divide the $100,000 by the 25.6 distribution period for 72-year-olds and you’d end up with about $3,906. This is the minimum you must withdraw from your traditional IRA this year, though you can take out more if you want. Failure to take out at least your RMD results in a 50% penalty on the amount you should have withdrawn.

Roth IRAs don’t have RMDs because you already paid taxes on those funds in the year you made your contributions, so you can leave them untouched as long as you want. This can give those savings more time to grow, so they could potentially be worth more in time.

If you decide you’d rather not deal with RMDs in retirement, you can always convert your traditional IRA funds to Roth IRA funds, but you must pay taxes in the year of the conversion if you do this. Whether or not that’s a smart move depends on your taxable income for the year and how you believe that compares to your spending in retirement, as discussed above.

3. You can take penalty-free Roth IRA withdrawals from your contributions at any time

Because you’ve already paid your taxes on your Roth IRA contributions, you can take them out at any time without paying taxes or a penalty. Traditional IRA distributions require you to pay taxes plus a 10% early withdrawal penalty if you make withdrawals under age 59 1/2 without a qualifying exception, like a first home purchase or a disability.

You could still owe taxes and penalties if you withdraw your Roth IRA earnings too soon, though. If you want to avoid extra charges on these withdrawals, you must wait until you’ve had your account for at least five years and until you’re at least 59 1/2. There are exceptions to early withdrawal penalties, just as there are with traditional IRAs, so you may be able to avoid extra charges if you qualify for one of these.

Just because you can withdraw funds from your Roth IRA early without paying a penalty doesn’t mean you should. Doing so will hamper the growth of your retirement savings and could threaten your future financial security. You should only do so if you have no other way of getting the funds you need.

Technically, you don’t have to choose between a traditional or Roth IRA. You can contribute some money to both, but you should favor whichever one you believe will offer you the best tax advantages. Remember to stay mindful of the annual contribution limits as well. You may contribute up to $6,000 to an IRA in 2020 or $7,000 if you’re 50 or older, but this limit applies to all your IRAs, not to each individually. You certainly don’t have to max out your IRA, but doing so is a great way to set yourself up for a comfortable retirement.

Originally published at https://www.fool.com on October 19, 2020.

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