When it comes
to IRAs there are two basic types: traditional and Roth. The simplest
difference is that a traditional IRA defers your tax liability until you
withdraw from the account, while Roth IRAs take out your tax liability at the
time of your investment. But don’t tune out yet, there are a lot of other
things to know about how IRAs work.
traditional IRA, you contribute pre-tax earnings, lower your tax liability for
that year and sit back and watch as that money grows on a tax-deferred basis
year after year. With a Roth IRA, you pay taxes on the amount of your
contribution upfront. Once you’ve paid those taxes, you don’t pay them again.
That means you don’t pay taxes when you withdraw the money.
To see how
this works, let’s do the math. For example, if you make $60,000 a year and
contribute $1,000 to a traditional IRA, you are only taxed on the remaining
$59,000. Even if you make trades or receive dividends from stocks, that income
remains tax-free. It’s important to keep in mind however that once you start withdrawing
money, it is considered income and you are taxed on the full amount of the
withdrawals. In any case, keep in mind that once you reach 70 ½ years old, you
are forced to withdraw money from the traditional IRA each year. This is known
as a required minimal distribution (RMD).
The age you
plan on retiring can have a significant impact on which type of IRA you choose.
If you plan on retiring early and don’t expect to be receiving a regular
income, you’ll probably want to consider a more aggressive approach to
investment such as the Roth IRA (or fill out your portfolio with dividend
earning stocks). The Roth IRA is the opposite of the traditional IRA in the sense that you don’t get any tax
breaks in the year you make contributions. So, to use our previous example,
let’s say you earned $60,000 and contributed $1,000. You’ll be taxed on the
full amount you’ve earned that year (in this case $60,000). There is no
required minimum distribution during your lifetime.
So which is
better for you? If, like many people you are in a higher tax bracket now and
expect to be in a lower tax bracket when you retire, financial planners usually
recommend going for the traditional IRA. For a Roth IRA, it’s just the
opposite. A Roth IRA can work wonders for people who have waited longer to
start saving for retirement. The reasoning behind it assumes that taxes will go
up and this way you will have the money to invest instead of having to pay the
government. This means you won’t be hit with a huge tax burden when you do
retire and provides an extra level of protection for your nest egg. In some
cases, it makes sense for one spouse to have one kind of IRA while the other
has another. Or for one person to have both. Remember to consult a financial
planner as your specifics will drive the ultimate decision.
is a contributing writer to www.myperfectfinancialadvisor.com, the premier matchmaker between investors
and advisors. Lee is an experienced journalist and editor with over 30 years of
expertise with a significant history of writing in the personal finance and