traditional ira and roth ira

Unless you are not considering saving for retirement, deciding on the ideal IRA (individual retirement account) to opt for is one hurdle you must face when making plans for the future. This is usually a crucial decision because the type of IRA you choose will determine how much money you’ll be entitled to when you finally stop working. Therefore, every investor should carefully examine the available IRA options, and analyze their differences before making a choice.

The two major types of IRAs are the 

    • Traditional IRA

    • Roth IRA

Although both accounts are similar, they also have their key differences.

Tax Breaks

You are bound to enjoy generous tax breaks with both traditional and Roth IRAs. Be that as it may, claiming them is a question of timing.

Traditional IRA allows tax-deductible contributions on both state and federal tax returns for the contribution period. However, when you retire, withdrawals will be taxed at your income tax rate.

With traditional IRAs, your taxable income in the contribution year is reduced. That brings down your adjusted gross income (AGI). This AGI reduction makes you eligible for other tax incentives that aren’t easily available, such as the child tax credit or the student loan interest deduction.

With Roth IRAs, you are being taxed in the contribution year, in exchange for tax-free withdrawals in retirement.

Income Limits

A traditional IRA is open to anyone earning an income regardless of the amount. However, if your income is really high, you may not be eligible for tax-deductible contributions. 

Roth IRAs, on the other hand, have income-qualification limitations: For 2020, singles MAGI must be below $139,000, with contributions being eliminated beginning with a MAGI of $124,000. For married couples their modified AGIs must be below $206,000 to contribute to a Roth, and contributions are phased out starting at $196,000.

In 2021, singles MAGI must be below $140,000, with contributions being eliminated beginning with a MAGI of $125,000. Married couples modified AGIs must be below $208,000 to contribute to a Roth, and contributions are eliminated beginning at $198,000.

Withdrawal Rules

With traditional IRAs, there is a mandatory rule that requires you to start making taxable withdrawals of a percentage of your funds at once you’ve clocked 72. It’s termed “required minimum distributions” (RMDs) The IRS offers worksheets to compute your yearly RMD, which depends on your age and the size of your account.

With Roth IRAs there is no such thing as “required minimum distributions”:  It is not mandatory to make any withdrawals at any age—or undoubtedly, during your lifetime at all. This feature makes them ideal wealth-transfer vehicles.

Early Withdrawals

With a traditional IRA any withdrawals made before age 59½, attracts taxes and a 10% early withdrawal penalty. In some special cases, the penalty can be avoided; for instance, if the money was spent on qualified higher education expenses or qualified first-time home-buyer expenses (up to $10,000), to cater for a permanent disability, or any other compulsory medical expense. 

Note: taxes cannot be avoided in any case.

On the contrary, a Roth IRA allows you to make withdrawals equal to your contributions before age 59½, at any time you wish, without questioning your reasons, with no penalty or tax attached.

However, in a case where you need to withdraw an amount bigger than your contribution, you can avoid taxes and the 10% early withdrawal penalty if you’ve had the Roth IRA for five years and above, and at least one of the below circumstances applies to you:

    • You are 59 ½ years old and above.

    • withdrawal by your beneficiary or estate when you die.

    • Have a permanent disability.

    • Use the money (up to a $10,000-lifetime maximum) for a first-time home purchase.

If you’ve had the account for less than five years, you can still avoid the 10% early withdrawal penalty if:

    • You’re at least 59 ½ years old.

    • withdrawal due to a disability or sudden financial crisis.

    • Your estate or beneficiary made the withdrawal after your death.

    • You use the money (up to a $10,000-lifetime maximum) for a first-time home purchase, qualified education expenses, or certain medical costs. 

Conclusion

IRAs are obviously a compelling method to put money aside for retirement on account of the tax reductions associated with them, and the tax-free growth they offer on your investments. Once you have done your research and consulted with your CPA or Investment advisor setting up an IRA is quite easy. Most banks and credit unions offer them, as well as through online brokers and investment companies. You can set up programmed contributions into your IRA from your checking or bank account, which makes contributing for your future one less thing to worry about.

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