You’ve probably heard that IRAs can be an excellent way to prepare for your financial future. However, there’s more than one type of IRA. If you’ve been asking, “what’s the difference between a Traditional IRA and a Roth IRA?”, keep reading to find out!
What is a Traditional IRA?
A Traditional IRA is a pre-tax account with tax deferral, which simply means that taxes are delayed. This means that you have not yet paid any tax on the money in the account. Therefore, anything that happens in the account (buying, selling, dividends, income distributions, etc.) does not have any immediate tax consequences. Instead, you only pay tax on the money when it is distributed to you from the account.
What is a Roth IRA?
A Roth IRA is a tax-free account type. It is funded with after-tax dollars (meaning you have already paid tax on the money). As with the Traditional IRA, anything that happens in the account does not have immediate tax consequences.
The main difference between the two is that a qualified distribution – meaning you are over the age of 59.5 AND the account has been open for at least 5 years – does not get taxed. If you have a million dollars in a Roth IRA, you can take out all of it without paying a cent in taxes.
What’s the difference between a Traditional IRA and a Roth IRA?
The main difference between a Traditional IRA and a Roth IRA is the way that they’re taxed. With a Traditional IRA, you’ll contribute pre-taxed dollars. Then, you’ll pay tax when the money is distributed to you later.
With a Roth IRA, the contributions have already been taxed. Therefore, after age 59.5, your withdrawals will be (in most cases) tax free.
So, which is better?
Which option should I choose?
The account type that makes the most sense for you depends largely on your current tax rate and your expected future tax rate. If you expect to pay more taxes in the future, the Roth account probably is the better of the two. If you expect lower taxation, the Traditional IRA will likely be more profitable for you.
To illustrate, let’s assume that your tax rate today is 20%, and you also expect your future tax rate to be 20%.
You invest $1000 of pre-tax money now in both account types, and withdraw it after it has doubled.
Your $1000 Traditional IRA grows to $2000, but you have to pay 20% tax on the withdrawal. This leaves you with $1,600 after tax. Your Roth IRA contribution was reduced by 20% tax up-front to $800, so doubling it also gives you $1,600.
One key difference that makes the Roth IRA more useful in many circumstances is that you can draw out the contributions at any time, for any reason, without paying tax. Only the earnings are subject to the qualifying distribution rules.
One example of using this fact to your advantage is saving toward college expenses. If you max out the contributions into an account for 18 years, you’ll wind up with north of $100,000 that is available tax-free. Most importantly, there won’t be any restrictions on use for the money. Meanwhile, the earnings will continue to grow to build a tax-free retirement account.
Beneficiaries usually also like to get tax-free money, so we try to put money that is likely not needed for the individual’s expenses into a Roth IRA to pass it on to the next generation in a tax-free manner.
Not sure what option is best for you?
Milestone Wealth Management exists to help you establish a plan for a secure financial future. We want you and your dependents to feel confident that you have a plan no matter what happens.
Whether you have questions about IRAs, other investments, how much you need to save for retirement, debt, or other financial concerns, we’re here for you. Book a meeting today and let’s create a comprehensive plan that works for you.
This material is not intended to replace the advice of a qualified tax advisor, attorney, or accountant. Consultation with the appropriate professional should be done before any financial commitments regarding the issues related to the situations above are made.
