Many U.S. employees are able to participate in a 401(k) retirement program that is offered to them through their employer. This program allows them to save and invest a portion of their paycheck into a fund on a tax-deferred basis. 401 (k) plans have been, and continue to be, one of the most stable and reliable pillars of any employee’s retirement program.
However, there are several other kinds of retirement accounts available, including two versions of an Individual Retirement Account (IRA). One is known as a Traditional IRA and the other is known as a Roth IRA. Both are retirement accounts that individuals can establish in order to fund their retirement years – even if they also have an employer-sponsored 401(k).
Traditional IRAs were created in 1975 and eligible taxpayers were able to take advantage of them beginning that year as well. An IRA is held at a custodian institution – such as a bank or brokerage house – and the funds can be invested in any instrument the custodian allows, such as certificates of deposit, stocks or mutual funds.
The primary benefit of a Traditional IRA is that earnings in the account, if any, grow on a tax-deferred basis. Taxes are paid on investment gains only when withdrawals are made in retirement, usually beginning at age 59.5. And since the interest on investment earnings, if any, will compound at a large rate through the years, the income tax paid during distribution, may pale in comparison. This can then be construed as a greater return on investments.
There are other potential benefits as well. The entire amount of your Traditional IRA contribution can be deducted on your income tax return (up to $5,500 annually, or $6,500 if you're 50 or older). However, this option is only available to those who do not have a retirement plan from work. If you do participate in a work-sponsored retirement plan, your income will dictate whether or not your IRA contribution is deductible.
In addition, with a Traditional IRA, there are no income restrictions. You can invest in a Traditional IRA no matter how much money you earn.
Though a Traditional IRA has some favorable advantages, there are also some features that may not correspond to your retirement goals. For instance, if you’re planning on working well into your 70s and beyond, you will not be able to continue to make contributions into a Traditional IRA account. All contributions into a Traditional IRA cease at age 70.5.
Also, at the same age, holders of a Traditional IRA must begin withdrawing funds from their account, according to the Required Minimum Distribution (RMD) rules as defined by the IRS. And as mentioned above, funds from a Traditional IRA are subject to taxation when they are withdrawn.
Roth IRAs are also a desirable retirement account but its approach is significantly different from a Traditional IRA. Whereas a Traditional IRA allows for earnings, if any, to be tax-deferred, while an income tax deduction on the funds contributed into the account is possible for some, a Roth IRA provides tax-free earnings but no tax deduction on the funds contributed into the account. A Roth IRA is funded with after-tax dollars which is what allows for the earnings to be tax-free when they are withdrawn.
There are other differences as well. Roth IRA participants can make contributions into their account for as long as they live; they do not have to stop at age 70.5. Also, the Required Minimum Distribution (RMD) rules do not apply to holders of a Roth IRA.
Also, though the yearly contribution limits are the same for both the Traditional and Roth IRA, there are income restrictions on who can participate in a Roth IRA. If your income exceeds certain limits, you may not contribute to a Roth IRA. And if your income should fall within certain ranges, the amount you’re allowed to contribute to a Roth IRA may be lowered.
Some taxpayers will be drawn to the immediate tax deduction that a Traditional IRA allows, whereas other taxpayers will be willing to forego the tax deduction in order to enjoy potentially tax-free income later on. Of course, as we discussed, there are other variables and nuances to consider so it’s best to consult with a tax professional to determine which IRA best suits your personal tax circumstances.
Finally, if you can’t decide between them, the IRS does allow you to split your contribution, so you could invest in both types of IRAs to enjoy the potential benefits of each.
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