Understand the differences between Roth IRA and Traditional IRA

Understand the differences between Roth IRA and Traditional IRA

If you’re thinking about how to plan your retirement and feel lost in the midst of so many financial terms, you’re not alone! Roth IRA, Traditional IRA, taxes, deductions… all of this may seem complicated, but the truth is that it doesn’t have to be. Let’s break it down and explain everything in a simple and straightforward way, like a good conversation between friends.

In this text, you’ll understand the differences between these two types of retirement accounts that are so popular in the United States. Let’s go?

What is an IRA (Individual Retirement Account)?

Before getting into the differences, it’s good to know the basics: an IRA is an individual retirement account that helps you save for the future with some tax incentives.

There are two main types: the Roth IRA and the Traditional IRA. The choice between them depends on your financial goals, current income and how you envision your situation when you retire.

Roth IRA

A Roth IRA is ideal for those who prefer to pay taxes now and get rid of them in the future. With this type of account, you contribute money that has already been taxed (i.e. no tax deduction at the time of contribution). However, when you retire, the money and accumulated profits can be withdrawn tax-free.

Main benefits:

• Tax-free withdrawals in retirement: This is a great relief, especially if you expect to be in a higher tax bracket in the future;
• Flexible withdrawals: You can withdraw your contributions (not profits) at any time without penalty;
• No required distributions: Unlike a Traditional IRA, you don’t have to start taking money out at age 73 (called Required Minimum Distribution, or RMD).

The Roth IRA can be a great option if you think your future earnings will be higher or want to avoid tax headaches later on.

Traditional IRA

With a Traditional IRA, you get an immediate tax benefit: contributions can be deducted from your taxable income, which means you pay less tax now.

However, the money will grow tax-free until you start withdrawing it in retirement, when it will be taxed as income.

Main benefits:

• Immediate tax deduction: Perfect if you want to reduce your tax bill today;
• Contributions until later: You can contribute until you’re 73;
• Tax-deferred growth: Your investment grows faster because you don’t pay tax during the accumulation process.

The Traditional IRA can be interesting for those who think they will be in a lower tax bracket in the future or want to save taxes now.

What are the practical differences?

The Roth IRA and the Traditional IRA have important differences. In the Roth IRA, contributions are not deductible, but withdrawals are tax-free, and there is no mandatory minimum distribution (RMD) requirement.

In addition, contributions can be withdrawn at any time without penalty, offering greater flexibility.

On the other hand, a Traditional IRA allows you to deduct contributions as long as you meet the income limits and IRS rules, but withdrawals are taxed as income.

This type of account requires an RMD and applies penalties for withdrawals before the age of 59½, with specific exceptions. These differences influence the choice according to each individual’s financial objectives and tax situation.

Which is best for you?

The answer is: it depends! You need to consider some important points. To help you, we’ve come up with some tips that will help you in the decision-making process. Check out the list below!

Choose a Roth IRA if:

• You expect to be in a higher tax bracket when you retire.
• You want to avoid RMDs and have more flexibility.
• You prefer to pay taxes now rather than in the future.

Choose the Traditional IRA if:

• You want a tax deduction now.
• You believe your tax bracket will be lower in retirement.
• You plan to accumulate as much as possible before you start withdrawing.

Contribution limits and other important rules

For 2024, the contribution limit for both accounts is $6,500 per year, or $7,500 if you’re 50 or older. In addition, the Roth IRA has income limits that may restrict your eligibility. For up-to-date details on income and contribution limits, it’s always a good idea to consult the official IRS website.

Conclusion

Whatever you choose, the important thing is to start as soon as possible. The sooner you start saving, the more your money can grow with the power of compound interest. And remember, if you need more information or help, seek out a financial advisor to guide you on your journey.

Now that you understand the differences between a Roth IRA and a Traditional IRA, which one makes more sense for your future? Let’s start planning!

Written by

Juliana Raquel