IRA and Roth IRA: The Differences Explained

As you consider the options available to you to invest for retirement, there are two big options to consider especially: IRA and Roth IRA accounts. These types of investment accounts are designed to provide you with a way to put money aside for retirement. While you could put money into a savings account or even tuck it under your mattress, there are some key benefits to using an IRA in any of its forms.

What Is An IRA?

An IRA is a Independent Retirement Account. The U.S. federal government as a way to give consumers a way to put money aside for retirement even if their employer did not offer some option established this type of account. For example, 30 years ago, it was very common for people to receive a pension from their employers. The employer would put away some funds for the employee so that after he retired from his position, he would receive monthly checks to help support him through his retirement years.

Pensions are hard to find today. Instead, many employers offer 401k retirement accounts. Though this is the most common employer sponsored retirement account, individuals who may not have this account available to them, or those who are not working through an employer are left out. For this reason, the government created the IRA. There are now two forms of the these accounts the Traditional IRA and Roth IRA.

The differences in these two types has to do with the way taxes are levied on them. Though no one wants to pay taxes on their income, there are some advantages to using these retirement accounts specifically because of these tax advantages. It all has to do with when money is taxed.

Traditional IRA

In a Traditional IRA, an individual is able to contribute money to their account prior to the money being taxed. If you work for an employer, for example, the payroll company your employer uses will withdraw your IRA contribution from your paycheck before any income taxes are charged to it. The funds will then enter into your IRA account with the financial institution you have decided that they should be managed by. Remember, IRA’s are not managed by employers.

The funds will grow in the account over your lifetime. You should not touch these funds. Early IRA withdrawals are very expensive and can cause you to face increased taxes and fines. You can begin to receive the funds when you reach retirement age. While the money is in the account, it is growing through compound interest. This means that the amount in the account continues to increase as long as the underlying investments (such as mutual funds in most cases) are growing. The founds grow on top of each other, meaning that the funds you earn in interest are added to the balance of the account so they can earn interest, too.

When you reach retirement age, you can begin to take qualified distributions from a Traditional IRA. These funds can be used as you see fit. However, the withdrawals are taxed at the time you withdraw the money.

This type of IRA account is best for those who are in a higher income bracket when they aer younger and want to put money away for retirement. In retirement, you likely have a lower income because you are not working and may not be receiving as much in other income forms. Therefore, by waiting until now to be tax it, the Traditional IRA account withdrawals will be taxed at a lower rate than the money would have been years prior.

Roth IRA

Perhaps this scenario does not work for you. Maybe you are making less now than you plan to make during your retirement years. When this is the case, consider the advantages of the Roth IRA.

A Roth IRA is a tax deferred retirement account. This means that the funds that enter your retirement account remain there for the long term without any taxes being levied on them. When you open Roth IRA accounts, the funds are directed from your employer into the account after the payroll company has taxed them as income. The funds are added to the account by the financial institution.

Throughout your lifetime, the funds will continue to grow in the account, as they do with a Traditional IRA. The difference here is that the funds are growing tax-free. You do not have to pay any type of tax on these funds when you withdraw the funds from the account as long as you make qualified distributions (rather than withdrawing from the IRA early.) As mentioned, this is beneficial for those who are making more in retirement in income than the amount they made when they set up the Roth IRA account years before.

Choosing the Right One for You

So, how can you select the right IRA for your particular need? Numerous factors play a role here, but in short, it is all about the income you make. The goal of any retirement account is to take advantage of the rules in place by the federal government to minimize taxes. You can do this, but only if you following the Traditional IRA or the Roth IRA rules set forth.

Select the type of retirement account that is right for your particular needs. In many cases, people are making more money now than when they will retire, but if you have significant investments that are likely to pay off through retirement, or perhaps you do not plan to retire early anyway, then using the Roth IRA account may be a better option.

One thing everyone should is to discuss a Traditional IRA and Roth IRA with your financial advisor. Your situation is unique and having a professional opinion about what options are best for you is always beneficial. In either case, you do want to have an IRA if at all possible. You may be able to make IRA contributions that can help you to live the retirement lifestyle you are hoping for.