Traditional IRA vs. Roth IRA: Which Works Better for You?

| January 16, 2013 | Grow Old | , | 1 Comment

We’ve written extensively here about the myriad reasons why it makes sense to contribute regularly to your 401(k) retirement account. But what if you don’t have a 401(k)?

Individual retirement accounts – more commonly known as IRAs – are your next-best option. Unlike 401(k)s, which are available solely through the workplace, anyone can open an IRA. IRAs are popular among self-employed individuals who work on a freelance or contract-work basis. Many small businesses also offer IRAs in lieu of the more expansive 401(k) plans.

So even if you don’t work in an office, there are ways to save for retirement. And the good news with IRAs is that, like with 401(k)s, there is more than one option.

There are two types of IRAs: traditional and Roth. Each of them offers very different advantages, depending on what you want to get out of your retirement savings account.

Traditional IRA

Traditional IRAs are tax-deferred retirement savings accounts. If you have a traditional IRA, you don’t get taxed on your contributions until you start making withdrawals when you retire. That means that all the capital gains, dividend income and interest you earn during the life of a traditional IRA compounds on an annual basis without being taxed.

Most people opt for a deductible IRA, which allows you to deduct any contributions you make to the account on your end-of-year tax return. In essence, you get reimbursed for any taxes you paid on IRA contributions throughout the course of the year.

There’s also a nondeductible option with traditional IRAs, which prevents you from making any deductions on your tax return. But nondeductible IRAs only apply to individuals making more than $59,000 a year, or couples that make more than $95,000 combined.

Deductible IRAs are obviously a far more appealing choice. Here are the requirements for opening one:

  • You must be younger than 70 ½ years when you open the account.
  • To deduct the entire amount, individuals must make less than $59,000 a year and married couples must make less than $95,000 a year.
  • If your spouse works for a company that offers a 401(k) plan, your IRA is only fully deductible if your combined income is less than $167,000.

If you work for a small business, chances are your company offers a SIMPLE (Savings Incentive March Plan for Employees of Small Employers) IRA. With SIMPLE IRAs, there are two options: you can contribute 3% of your annual salary to your retirement account and your company will match it, or you can make no contributions and your company will instead contribute a flat 2% of your salary.

Whether you are self-employed or work for a small business, there are plenty of options when it comes to traditional IRAs – and the perks of opening such an account are obvious. The only catches are that you essentially pay an “exit fee” when you withdraw your earnings from the IRA. There’s also a restriction that prevents you from withdrawing money from the account prior to age 59 ½ without incurring a 10% penalty.

If those are sticking points for you, then you may want to try a…

Roth IRA

In essence, a Roth IRA is the reverse of a traditional IRA.

With Roth IRAs, there is no up-front tax break like there is with traditional IRAs. The contributions you make to a Roth IRA are not tax deductible.

However, unlike a traditional IRA, you do not get taxed when you withdraw money from a Roth IRA. Every dime you earn during the life of your Roth retirement account belongs to you! For younger investors with a long investment time horizon, the Roth IRA allows your investments to grow and the profits will go completely untaxed.

Another advantage of having a Roth IRA is that you can withdraw money from it at any time under certain conditions. Those are:

  • If you are paying off college expenses for you, your spouse, your children or grandchildren.
  • To pay off medical expenses that are more than 7.5% of your gross annual income.
  • If you are a first-time homebuyer, you can withdraw up to $10,000.
  • To cover any costs associated with a sudden disability.

Also, unlike with a traditional IRA, you aren’t forced to begin withdrawing money from it at age 70 ½. In other words, Roth IRAs give you the flexibility to either leave the account untouched until you’re 100 years old, or withdraw money from it without penalty at age 35 to help with a down payment on your first home.

Bottom Line

There are pluses and minuses with both traditional and Roth IRAs. Traditional IRAs ding you with taxes on the back end, while Roth IRAs force you to pay taxes up front.

Personally, I think the Roth is the better option. It gives you the flexibility to withdraw at any time if you need money for a new house or to pay off a student loan. And the fact that the government can’t touch your earnings in a Roth makes it more appealing than a traditional IRA.

Regardless of which option you choose, however, it’s important to start saving money for retirement early and often. IRAs allow you to do that even if you don’t work for a Fortune 500 company that offers a 401(k) plan with a contribution of 6% of your annual salary.

Even if you’re a freelance writer or independent contractor, you can start saving for retirement now. Opening an IRA is the best way to do it.

Read more from Investor Bistro about saving money for retirement

401(k) Retirement Plans: Fewer Investment Choices is Best

Carefree Retirement Investments

401(k) Loans: Should You Borrow from Your Retirement?

401(k) Contribution: How Much Should I Invest?

One Comment

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