If there's one thing that the American educational system fails at, it's educating the youth about their finances. It teaches algebra, chemistry, American history, and many more things yet it neglects budgeting, investing, and how to pay taxes. This led me to begin to educate myself on personal finance in general; I realized I had to take things into my own hands. While I certainly do not know everything, I have learned a sizable amount. Today, I want to talk about IRA's and the key characteristics attributed to a Traditional IRA and a Roth IRA.
What is an IRA?
IRA is an abbreviation which stands for "Individual Retirement Account." We as individuals are able to use these retirement accounts as a tool to save money and invest it for our retirement down the road. There are two different forms of IRA's - Traditional IRA's and Roth IRA's. Each has its' own pros and cons, and which one you choose to utilize will depend on your current financial situation; more specifically, it typically depends on your income.
One misconception I'd like to clear up before explaining the pros and cons of each IRA is that an IRA is a vehicle for investment. What do I mean by that? These retirement accounts are places for you to invest, not things for you to invest in. They simply hold your investments until you are ready to cash out for your retirement.
For example, let's say you opened a traditional IRA with any one of the big financial institutions. Once you have opened the IRA, you still have to choose what you want to invest in within the account. This could be stocks, index funds, real estate, etc.
Traditional IRA: Key Features
Traditional IRA's are contributed to with either pre-tax or post-tax dollars. This allows your investment in a traditional IRA to be deducted from your taxes, saving you money in the present. Unfortunately, the downside is that when you go to withdrawal your investments, they are subject to taxes. For both traditional IRA's and Roth IRA's, your investments cannot be withdrawn until after age 59 1/2, otherwise you will be subject to penalties for early withdrawal.
This year, as it has been in the past few years, the contribution limit for a traditional IRA is set at $6,000. If you happen to be over the age of 50, the contribution limit is bumped up to $7,000. In short, this means you cannot invest anymore than that $6,000 or $7,000 annually.
Luckily, in the case of a traditional IRA, there is no limit on earned income in order to be eligible to contribute. This will make more sense once I have explained a Roth IRA, but essentially it means that regardless of whether you make $15,000 and $500,ooo a year, you can still invest in a traditional IRA.
Lastly, traditional IRA's do come with mandatory distributions starting at age 72. This means that a minimum amount of money must be withdrawn once that age has been reached; the money can't sit in the traditional IRA forever.
Roth IRA: Key Features
Contrary to the traditional IRA, Roth IRA's are contributed to with post-tax dollars. While this takes away any immediate tax benefits, the money is tax-free when withdrawn. This can be very advantageous if you are currently in a low tax bracket. Same as the traditional IRA, money cannot be withdrawn until after the age of 59 1/2, otherwise the money will be subject to penalties and fees.
In terms of contribution limits, a Roth IRA has the same limit as a traditional IRA: $6,000 for those under age 50, $7,000 for those over age 50.
With Roth IRA's, unfortunately, there is an earned income limit in order to be able to invest. This means that once you make a certain amount of money, you're making too much to be allowed to invest in a Roth IRA; you must find somewhere else to invest your money. Income limits are split into two categories, one for single tax filers, and one for married tax filers. For single tax filers, the earned income limit is $129,000 up until $144,000, at which point you are completely cut off from investing in your Roth IRA. Within that range, you are still able to invest in the IRA, but you will be limited to less than the annual contribution limit. These same policies apply to married couples, although the numbers are $204,000 and $214,000, respectively.
Lastly, for Roth IRA's, distribution is not mandatory. If you so desired to let your money compound and you never had a need to touch it, you wouldn't be required to.
Which IRA should I use?
Disclaimer: I am in no way, shape, or form a financial adviser. This is simply my philosophy following some research.
Because of the ability to grow your money tax-free in a Roth IRA, they are typically suited best for those who are currently in a low tax bracket and expect to find themselves in a much higher tax bracket later in life. This allows you to pay minimal taxes upfront and reap the benefits of compound interest later without being taxed on it.
For those who are already in a high tax bracket, or expect to remain in the same tax bracket through their retirement, a traditional IRA is most likely a better fit. These individuals can use their investments as tax deductions and defer tax payments until they withdraw the money. This is beneficial because if your tax bracket never increases, you will be paying the same amount of taxes on your investment regardless; you might as well get the deductions.
I hope this was helpful for anyone confused on what IRA's are and the key differences between a traditional IRA and a Roth IRA. Now, put this information to use!