Introduction
Almost everyone is looking forward to retirement, that time of their lives that they will be largely free from work and one in which they will be at liberty to take long vacations at beach sides in Europe. However, for that to be a reality, they must put some plans in place – especially financially. One of the most common approaches to this is saving up funds for retirement via the individual retirement account (IRA).
While there are different types of the IRA, by far the most popular are the Roth IRA and the Traditional IRA. Here, we will take a look at both, with a focus on their differences.
The Roth IRA
The Roth IRA is a type of individual retirement account that offers tax-free savings growth and withdrawal to its users. The key feature of the Roth IRA is that the tax fees related to the savings in such an account have been committed beforehand. That is, you pay taxes when allocating funds into the account. So, this means that no taxes will accrue to the funds any longer after that. Thus, whenever there is growth in the assets in the account, no taxes will accrue. Any withdrawals made from the account will also attract no taxes.
Traditional IRA
On the other hand, traditional IRAs give users the advantage of committing pre-tax dollars to their retirement accounts, only incurring taxes on them at withdrawal. In short, rather than pay taxes upfront, you only have to pay them at the point of withdrawing funds from the account. You should note that the taxes essentially start applying after retirement.
Furthermore, even though there are penalties for withdrawals before a certain time, those penalties or taxes do not apply to such expenses as purchase of a first home, birth or adoption expenses, or college spending.
Similarities
The Traditional and Roth IRA, in spite of their differences, share some similarities. These include:
- Only income tax, no capital gains tax
Anytime you commit funds into an IRA, you are investing. This is because the fund manager with which your IRA is domiciled will allocate the capital across various markets – stocks, bonds, real estate and more. Ideally, any returns you get from investing in whatever form will attract capital gains tax, which are almost always very high. However, with IRAs – especially the traditional and Roth IRAs – there is no capital gains tax. The only tax that applies is the income tax.
- Income and Contribution Ceilings
While the income bracket and the maximum amount of contributions per annum may vary slightly from year to year, they are usually almost the same for both Traditional and Roth IRAs.
Differences between Roth IRA and Traditional IRA
While the Roth and Traditional IRAs share a lot of similarities, they also differ in a variety of ways.
- Method and Time of Taxation
By far, the most significant difference between both types of IRA is the system of taxation that applies to either of them. For the Roth IRA, you get to bear all the tax responsibilities upfront right from the point at which you are committing assets to the IRA. On the other hand, with the traditional IRA, you incur taxes at the point at which you choose to withdraw any part of the accrued balance in the IRA.
Hence, your choice between both will be a question of what you believe the tax rates will be at any particular time, and your attitude to taxes, generally.
- Penalties
Some differences also exist in terms of the “penalties” that apply when you take some actions. For instance, with the traditional IRA, if you take out some of the funds before you close the age of 591/2, you will be liable to a 10% penalty. This is most likely due to the fact that taxes have not officially kicked in, as they can only apply at retirement. However, you still must pay some form of “tax,” hence the penalty. But for the Roth IRA, no penalties apply, most likely because you have already paid up taxes beforehand.
- Forced Distributions
It may happen that even after retirement, you don’t have the need to take out of the IRA and choose to leave the capital there. Whether you will be allowed to do this at liberty will be determined by the IRA type you chose. Under a Traditional IRA, the government mandates that you start taking up distributions from the account when you clock 701/2. This, nevertheless, does not apply to a Roth IRA. Both the Roth and Traditional IRAs have their areas of strengths and downsides, and therefore when choosing, you only have to pay attention to your financial peculiarities.