An IRA is one of the most common retirement accounts available to investors when planning for retirement. While there are a few different types of IRAs, the two types that most investors choose between is the Roth IRA or the Traditional IRA. The main differences between the Roth IRA and the Traditional IRA are how and when the contributions are taxed, but the Roth IRA provides additional advantages as well for investors such as tax-free withdrawals, no required minimum distributions, and even the ability to access a portion of savings before the age of 59 ½. Roth IRAs can offer investors more flexibility in planning their retirement.
To really understand the benefits of a Roth IRA, investors need to understand what a Traditional IRA is. A Traditional IRA is an IRA in which contributions are made tax-free and earnings grow tax deferred. This means that, generally, investors who contribute to a Traditional IRA receive a tax deduction on their income today for their contributions but will defer taxes into the future. When withdrawals are made, investors will report the withdrawal as ordinary income. Dividends, income, and capital gains are not taxed with in a Traditional IRA. While there are some benefits to a Traditional IRA, there are some restrictions to them as well. There are income limits that apply to determine if an investor can take a deduction for their contributions to a Traditional IRA and requirements to begin taking withdrawals from the account after age 72. Furthermore, early withdrawals from the account come with a 10% penalty in addition to being taxed as ordinary income.
Roth IRAs, on the other hand, have some seemingly subtle, but powerful differences. The main difference for the Roth IRA is that investors do not receive a tax deduction today on their income. Instead, investors pay tax on their income today and allow their investments to grow tax free. That means that dividends, interest, and capital gains are not taxed in a Roth IRA, like a Traditional IRA, but additionally withdrawals from a Roth IRA are tax free. This difference alone can be a powerful reason to choose a Roth IRA when investing and opens many planning opportunities, specifically for young professionals or children.
Another main benefit to choosing a Roth IRA is the lack of a required minimum distribution, or RMD. The government requires investors to take a minimum amount of their Traditional IRAs. This can sometimes be annoying for investors who do not need their money at that time and can potentially even be expensive, pushing them into higher tax brackets. Investors who utilize Roth IRAs never have to access those funds if they do not want too and can leave them to beneficiaries when they pass. Finally, Roth IRAs allow the tax free withdrawals of their contributions at any time. This can be used creatively in financial planning to help pay for children’s college or to just make yourself a bridge loan during a tough time.
Roth IRAs provide investors, and their planners, flexibility in how to plan for retirement and life’s expenses. They are a great tool for passing wealth along through generations, savings vehicles for younger individuals, and can provide enormous tax benefits for young investors. Roth IRAs can also be used in conjunction with Traditional IRAs to allow otherwise ineligible investors contribute to IRAs through the conversions, commonly referred to as “Backdoor Roths”. The decision between a Roth IRA or a Traditional IRA can be extremely simple, depending on your income, but consider speaking to a financial advisor about the ways you can use the advantages in a Roth IRA.
Rick D. Bernard | MBA