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What’s the Difference Between a Traditional IRA and a Roth IRA?

It may feel too soon for retirement planning, but the sooner you understand how different retirement accounts work, the more prepared you’ll be for your future.

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Oct 25, 20194 minutes

According to Bloomberg, almost half of Americans approaching retirement have nothing saved in a 401(k) or other retirement account. When it comes to saving for retirement, the sooner you start saving, the more money you’ll have by your retirement age.

Time is on your side when you start saving early on in your career because of compound interest; this is the process by which a sum of money grows exponentially due to interest building on itself. Knowing what type of plans are available to you is a great first step in the financial plan for your future.

A 401(k) is a retirement savings plan that an employer sets up for their employees. But IRAs or Individual Retirement Accounts, are retirement savings accounts that are opened, owned, and maintained by individuals and not by the employer.

The most common types of IRAs are traditional and Roth. Each type comes with its own eligibility rules and annual contribution limits, but let’s dive into what differentiates the two.

Traditional IRA

Anyone who is employed and who has a regular income can open an IRA, even if you already have an open 401(k) through your employer.

Contributions to a traditional IRA account are tax deferred, meaning that you’ll save money in the short term and will not pay income taxes for your savings until you withdraw funds post retirement. The IRA contribution limit is subject to annual changes. The 2020 limit is $6,000 ($7,000 for account holders aged 50 or older).

Early withdrawal might be subjected to 10% fee. However, you can use the funds kept in a traditional IRA to pay for qualified college expenses and toward buying your first home (up to $10,000), without paying an early distribution penalty.

Roth IRA

Roth IRAs are similar to traditional IRAs in that they have the same annual contribution limit, and they both can be comprised of a range of investment options (stocks, bonds, mutual funds, etc.) that collectively go toward your retirement savings. Due to the fact that your contributions to a Roth IRA are all after-tax, you will have the advantage of being able to pay the current tax rate, as opposed to having to pay an unpredictable tax rate down the road.

You can use Roth IRA money to pay for qualified college expenses without being charged an early distribution penalty. Since you will have already paid taxes on them, you can withdraw your contribution funds before you retire without being subjected to a tax or penalty. However, if you withdraw any investment earnings, you may be taxed or penalized.

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Which Plan is Right for You?

The one crucial difference between the two types of IRAs is the money in a traditional IRA is tax-deferred, but the money that is put into a Roth IRA is after-tax income. In other words, federal income taxes are taken from all contributions to a Roth IRA, which means you’ll be able to access the money tax-free post-retirement.

Generally, picking a traditional IRA could be a good option if you expect to be in a lower tax bracket when you retire, because when you do retire and start withdrawing money, you'll end up paying less in taxes overall. If you expect to be in the same or a higher tax bracket when you retire, you may want to consider contributing to a Roth IRA, which allows you to get your tax bill settled now rather than later.

But it can be difficult to guess what tax bracket you will be in later in life, especially if you've got a long way to go until you retire. So if you're not sure, a good rule of thumb is to keep your retirement savings tax diversified, meaning you have accounts that will be both taxable and tax-free when you cash out in retirement. Typically, Roth IRAs are more popular options for someone who is in the earlier stages of their career, but both are great options either on their own or in addition to a 401(k) plan through an employer.

Both traditional IRAs and Roth IRAs are important to consider when you are engaging in financial planning. These accounts can help you to reach your savings goals so that you can retire comfortably. It’s important to explore your options and there are various tools to help you along like NerdWallet’s Retirement Calculator. You can also check out some IRA plan comparison sites before making a decision on the plan you want.

It’s never too early to start planning and saving for your retirement. The sooner you’re able to start regularly setting aside funds, the more they’ll compound, and the better off you and your family will be once you reach the retirement stage of your life.

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, legal or tax advice. If you have any legal or tax questions regarding this content or related issues, then you should consult with your professional legal or tax advisor.