When planning for your retirement there are two key savings mechanisms that you can use, a traditional Individual Retirement Account (IRA) and a Roth IRA. While they sound very similar there are distinct differences between the two retirement savings programs and understanding them clearly is important. This article will highlight those differences and explain how you should be deciding between an IRA vs. a Roth IRA.

IRA

A traditional IRA is a tax savings account provided by the IRS that allows any income generated in the IRA to be tax free while kept in the account. Significant details of a traditional IRA include:
  • Contribution Limit: Total contribution allowed is $5,500 per year, but accelerates to $6,500 per year if 50 or older. No contributions are allowed after reaching 70 ½.
  • Tax Deduction: During the year you make a contribution you receive a deduction for the amount contributed, which can significantly reduce your tax bill or generate a refund.
  • Withdrawals: All withdrawals are treated as taxable income. Withdrawals before age 59 ½ will result in an additional 10% early withdrawal penalty. An exception is you can withdraw up to $10,000 without penalty to pay for qualified first-time homebuyer expenses.
  • Mandatory Withdrawals: After you reach 70 ½ you will be required to take required minimal distributions from your account.

Roth IRA

A Roth IRA is similar to a traditional IRA in that the IRS allows income generated in the IRA to be tax free, however, there are numerous differences in terms of how a Roth IRA operates.
  • Contribution Limit: Total contribution limit allowed is $5,500 per year, and also accelerates to $6,500 per year if 50 or older. The contribution limit between Roth and traditional IRA's is shared.
  • Tax Deduction: No tax deduction is generated when contributions are made.
  • Withdrawals: You can withdrawal any amounts contributed, plus income earned on them, tax free as long as your first contribution is at least 5 years before you make a withdrawal.
  • Mandatory Withdrawals: No mandatory withdrawals exist with during the tax payer's life. Currently Roth IRA's can also be passed on to beneficiaries who will receive the same tax free withdrawal benefits.

IRA vs. Roth IRA

When choosing between contributing to a Roth IRA or a traditional IRA you should consider the tax rate you pay now and what you expect to pay in the future. A traditional IRA will reduce your tax burden now, so if you pay a higher rate now than you expect to later this may be the best option. Projecting your future tax rate in 10 years is difficult, let alone 30, so naturally this can be fairly difficult to estimate.

If you are in a position where the immediate tax deduction of a traditional IRA is not overly significant to your current financial picture you may want to consider contributing to a Roth IRA instead. The additional flexibility in terms of withdrawals later in life, as well as the ability to pass it on to your beneficiaries can be substantial. Hopefully this article will assist in ensuring you make the best decision for your financial future.