When saving for retirement, many people consider individual retirement accounts (IRAs). The two types of IRAs are traditional and Roth—the primary difference is how and when your money is taxed.
What is an IRA?
An IRA is a retirement vehicle created by the federal government to encourage individuals to save. The money contributed to them can grow tax deferred. This can be a powerful advantage to you. Because if you don’t pay taxes on this growth while it’s in the IRA, your money may compound faster than it would if it were taxed immediately.
In addition:
- A traditional IRA has the potential for you to make tax-deductible contributions to your retirement, and the earnings are taxable only when you make a withdrawal.
- Roth IRAcontributions are not tax-deductible, meaning that you’re contributing money you’ve already paid taxes on. But you are allowed to make “qualified withdrawals” of earnings that are tax- and penalty-free.
Is an IRA a mutual fund?
The short answer is no. The biggest difference between an IRA and a mutual fund is that an IRA is a type of account that can be funded with an investment like a mutual fund, an annuity, or any number of other investment vehicles.
It usually depends on the institution that you’re opening the IRA with as to what type of investment it can be funded with. For example, a mutual fund company will usually offer mutual funds to invest your IRA in, an insurance company will offer annuities, a bank will offer CDs, and a brokerage firm may offer stocks and bonds.
As with any investment decision, deciding which type of vehicle to use to fund your IRA will depend on your objectives, your risk tolerance, and your investing timeline. Just keep in mind: The sooner you start your IRA, the longer your assets may grow to help you meet your retirement goals.
Let’s take a look at this handy chart for details on the differences of each type of IRA.
Comparing Traditional IRA and Roth IRA
Traditional IRA | Roth IRA | |
|---|---|---|
Who is eligible? | Anyone who has earned income. | Anyone who has earned income, but the contribution amount is based onand their Modified Adjusted Gross Income (MAGI). For single filers, that would include anyone with MAGI under $138,000 for the 2023 tax year and under $146,000 for 2024. Contributions would be reduced on a sliding scale between $138,000 and $153,000 for 2023 and between $146,000 and $161,000 for 2024. Married couples filing jointly must have MAGI between $218,000 and $228,000 for 2023 and between $230,000 and $240,000 in 2024 to qualify for a Roth IRA, with contributions reduced on a sliding scale. |
What is the maximum amount that can be contributed each year? | $6,500; $7,500 if over age 50 (for 2023), and $7,000 or $8,000 if 50 or over in 2024. | $6,500; $7,500 if over age 50 (for 2023), and $7,000 or $8,000 if 50 or over in 2024. |
What are the tax advantages? | You may be able to deduct your contributions from income taxes. And any growth in the account is not taxable until you withdraw it. | Any growth in the account is not taxable until you withdraw it—and may even be tax-free if certain conditions are met. |
Is the contribution deductible from taxes? | Yes, unless you or your spouse participate in an employer-sponsored retirement plan and your MAGI exceeds certain dollar amounts (see IRS contributions and deduction limits). | No. |
What happens when I make withdrawals? | Withdrawals made before age 59½ may be subject to a 10% federal tax penalty unless certain conditions exist, in addition to ordinary income taxes. | Contributions are withdrawn first without tax or penalty. Withdrawals of earnings are income tax- and penalty-free if the IRA has been held for at least five years and you are at least age 59½, disabled, first time home purchase ($10,000) or paid to your beneficiary. |
Am I required to take distributions? | Yes, you must begin taking distributions once you turn age 73. | No distributions are required for you, but your beneficiary will be subject to distribution requirements. |
Best of both worlds
If it makes sense in your scenario, you could contribute to both types of IRAs to take advantage of the unique benefits each account offers. The annual contribution limit can be split between your IRAs. And if you currently have a traditional IRA and decide a Roth IRA would be a better fit, you couldconvert your traditional IRA account into a Roth. Keep in mind part or all of the distribution may be subject to income tax.
The good news is you have options. Learn more about Roth IRA conversions.
The information provided is not intended as a source for tax, legal or accounting advice. Please consult with a legal and/or tax professional for specific information regarding your individual situation.
I've got a solid grip on IRAs and retirement planning! Let's dive into the wealth of concepts packed in that article:
IRA Basics: An Individual Retirement Account (IRA) is a government-created vehicle for retirement savings. It offers tax advantages, allowing contributions to grow tax-deferred, which means your investments can compound without immediate taxation.
Traditional IRA vs. Roth IRA:
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Tax Treatment:
- Traditional IRA: Contributions may be tax-deductible, and earnings are taxed upon withdrawal.
- Roth IRA: Contributions are made with post-tax income; qualified withdrawals, including earnings, are tax-free.
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Eligibility:
- Traditional IRA: Open to anyone with earned income.
- Roth IRA: Eligibility depends on income levels (Modified Adjusted Gross Income - MAGI). Limits apply to contributions based on income levels.
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Contribution Limits:
- Both types share the same contribution limits, with catch-up contributions available for those aged 50 or older.
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Tax Advantages:
- Both IRAs offer tax-free growth on investments, albeit at different points (contribution vs. withdrawal).
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Tax Deductibility:
- Traditional IRAs may provide a tax deduction, whereas Roth IRAs do not.
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Withdrawals:
- Early withdrawals from a Traditional IRA might incur penalties and taxes.
- Roth IRA allows penalty-free withdrawals of contributions, with earnings being tax-free if certain conditions are met.
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Required Minimum Distributions (RMDs):
- Traditional IRAs require distributions starting at age 72, while Roth IRAs don’t mandate withdrawals during the account holder's lifetime.
Converting Between IRAs: You can convert a Traditional IRA into a Roth IRA, potentially enjoying tax benefits in the long run. However, taxes might apply on the converted amount.
Hybrid Approach: For those eligible, contributing to both types of IRAs is an option, leveraging the distinct benefits each account offers.
Investment Choices within IRAs: IRAs aren't mutual funds themselves but accounts that can hold various investments, including mutual funds, stocks, bonds, annuities, CDs, etc. The investment options often depend on the institution managing the IRA.
Consultation Reminder: It's crucial to seek personalized advice from legal, tax, or financial professionals regarding individual circ*mstances before making IRA decisions.
Navigating retirement savings involves understanding tax implications, contribution limits, eligibility criteria, and long-term planning. Both types of IRAs present advantages, catering to different financial strategies and circ*mstances. The key is aligning these options with personal retirement goals and financial circ*mstances.
