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The acronym IRA that stands for “Individual Retirement Arrangement” is probably well known to those who are planning for retirement and trying to understand what options they have on offer.
Put more simply, IRA is the individual retirement account that is not an employer pension plan referred to as 401(k). Created for retirement savings, this account provides certain tax advantages to its holders.
Another distinguishing feature of IRA is that it can be invested into any asset ranging from stocks to cash investments.
Most prominent other words that appear in conjunction with the acronym IRA is “Traditional” and “Roth.”
The “Traditional IRA” and the “RothIRA” are two types of the Individual Retirement Account between which most of the people shuttle unable to understand how they are different and which one they should choose.
In what follows, we add more information to Wealthfront’s Roth IRA review and clarify the main dissimilarities and similarities between the two accounts.
Choosing correctly between the two IRAs will make a world of difference in your retirement years.
The chief difference between the Traditional IRAand Roth IRA is taxes and how they are approached in each type.
If you decide to prefer Traditional Ira, you will use pre-tax dollars, thereby decreasing your taxable income.
Provided you consistently contribute a certain amount to the Traditional IRA, it will tax not your whole annual income but a lesser percentage of it.
But how much will be deducted from you will also depend on any other retirement plans that you may have in addition to your Traditional IRA.
In the case when you also have the 401(K) or when your spouse has the workplace retirement plan, it will depend on your modified adjusted gross income and your tax filing status whether you will be given a full deduction or no deduction at all.
What you also need to understand about the tax deduction with the Traditional IRA is that, even if you may receive a tax deduction now, you will pay taxes on any investment growth when you withdraw your money when retired.
You will also pay taxes on your contribution. There is yet another caveat: should you withdraw your money before you turn sixty, you will be charged an additional 10 percent tax penalty for the early withdrawal.
The tax situation with the Roth IRA is as follows:you will have no tax deduction on the contribution you presently make.
Any money placed in this account will be post tax money. Yet there is also a positive side to the Roth IRA’s taxing rules: any withdrawals you will make in retirement will be tax-free, and so will be any investment growth.
But again, you should not make withdrawals from your Roth IRA before you turn sixty.
Nor should you do this before your account has been activated for five years. What is also appealing in the Roth IRA is that it will permit you to access the contribution you make now and will not charge you additional taxes for this.
But it will not let you access the investment growth under the same conditions.
The Traditional and the Roth IRAs are subjected differently to the RMD rule.
If you open the Traditional Individual RetirementAccount, you will need to follow a Required Minimum Distribution (RMD): you will need to start withdrawing a minimum amount from your account after you turn seventy.
The first withdrawal is usually set on the first of April after your birthday, whenever it is.
If you do not begin to withdraw the required minimum, you will be penalized. The Roth IRA has no such rules. You can keep all your money in your account as long as you want.
As may be clear by now, both IRA accounts have their merits and demerits. Your choice of the specific IRA should also depend on your specific circumstances.
But there are reasons why the Roth IRA may be preferable over the Traditional account.
If you do not pay large taxes at present, the Roth IRA may be a better option for you, because you do not need a tax deduction.
Younger retirement savers also should opt for the Roth IRA. The younger you are the longer growth your contributions will have. You will also be glad later not to pay taxes on this long growth.
There are other minor considerations to take into account when choosing the right retirement plan. If you are still in doubt, you may want to consult a financial planner or tax advisor who will help you make your final decision about your Individual Retirement Account.