Recently, I have been aggressively pursuing the idea of building long term wealth to achieve financial freedom. As I researched different investment vehicles, one investment vehicle popped up over and over again, and that vehicle was an Individual Retirement Account (IRA). Now I had pretty much a rough idea of what this account was, but I didn’t know exactly what benefits the account offered, and I especially didn’t know the difference between a Roth IRA vs Traditional IRA.
So what I have done here is put together a list of the similarities and differences between a Roth IRA vs Traditional IRA, the advantages and disadvantages of both of them, and which one I would recommend you get started with as a long term investor.
What is an IRA?
The first note to make before breaking down the two subcategories of an IRA is to understand what an Individual Retirement Account (IRA) is in the first place.
An IRA is an account set up through a brokerage company or financial institution that allows an individual to save for retirement in a tax-advantaged way. This account can be open in conjunction with a retirement account that is already offered by an employer, such as a 401(k) or 403(b). The tax advantages offered by an IRA could be: deferring taxes until a later date, paying taxes now in order to get tax free growth or both.
With an IRA account, there aren’t typically any age restrictions for you to open an account. It is a very easy process as I was able to open my very own IRA account in less than 5 minutes with the brokerage company, Charles Schwab.
The purpose of an IRA to help cushion your financial needs further into retirement if your employer-sponsored financial plans don’t meet your needs adequately.
A traditional IRA is a subset of the basic IRA, however, the main difference that an account like this has over the other IRA accounts is that it allows you to contribute pre-tax dollars. This means that any money that you put into a traditional IRA will be deductible on your tax statements, allowing you to get a refund on that portion from the federal goverment.
The investments that you make can then grow tax-deferred until you begin to withdraw money, which would then require you to pay taxes on the money at your future income bracket level.
A traditional IRA is great for individuals who think that their income bracket level will be lower in the future, as it allows them to get taxed at a lower rate. However, a major drawback of a traditional IRA is that any money that is withdrawn before the age of 59 1/2 will be subject to a 10% withdrawal penalty. Also, mandatory withdrawals are required once a person reaches the age of 70 1/2, so the government can begin taking their slice of the pie.
|Capital gains are deferred until you begin to withdraw money||10% withdrawal penalty if money id withdrawn before the age of 59 1/2|
|You can deduct contributions on your current year tax return||Mandatory withdrawals at the age of 70 1/2 so that the government can begin to collect taxes on your gain|
A Traditional IRA has an annual contribution limit of $6,000 for individuals ($7,000 if you are over the age of 50) as of 2020.
A Roth IRA is different from a traditional IRA in one major way, tax treatment. With a Roth IRA, you pay taxes on the money that you contribute today so that all of the gains that you receive on your investments in the future can be withdrawn tax-free. This differs from a Traditional IRA, because with a Roth IRA, you will not be able to deduct any contributions on your tax statements.
Also, with a Roth IRA, there are income restrictions that limit who can contribute. As an individual filer in the year 2020, you can contribute a maximum of $6,000 to a Roth IRA account if your income is below $124,000. If your adjusted gross income in more than $124,000, but less than $139,000 in 2020, you can still make partial contributions.
There are still early withdrawal penalties with a Roth IRA as well. If you were to withdraw your money before the age of 59 1/2, and after not having the account open for more than 5 years, you will be subject to the same 10% early withdrawal penalty as a traditional IRA.
A Roth IRA is an excellent investment vehicle to utilize if you believe that your income bracket will be higher in the future.
|Tax-free growth on all gains||10% early withdrawal penalty|
|No mandatory withdrawals ever||Contributions are not tax-deductible|
A Roth IRA has the same contribution limit of a traditional IRA of $6,000 for an individual ($7,000 for an individual who is over 50) as of 2020.
Which IRA should I choose?
If you are looking to invest to build wealth over a long period of time, you can’t go wrong with choosing either a Roth IRA vs Traditional IRA. The similarities between the two are evident in that both:
- Have no age requirements on who can start and contribute
- Allow you to contribute a maximum of $6,000 for individuals under the age of 50
- Provide the opportunity for tax advantaged growth
However, if you are someone who believes that your income will increase over time, then I recommend that you open a Roth IRA account. This allows you to contribute right now at your current income level, and all of the gains that you have will then be tax-free.
If you are someone who thinks that their income bracket will be lower in retirement, then a Traditional IRA account may be a better fit for you because the money that is withdrawn in the future will be taxed at your future income bracket level.
At the end of the day, it is all about analyzing your own personal financial situation so that you can ensure that you are making the best call for yourself and loved ones.
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