Using either a Traditional or Roth IRA can provide tremendous tax advantages for accumulating wealth and assets for retirement. But what are the differences between a Traditional and Roth IRA?
Think of an IRA as a tax advantaged investment container. When you make a contribution, you are putting funds inside the IRA container. Those funds can then be invested. Any earnings, gains or interest are generally allowed to grow and be reinvested without paying taxes as long as they are inside the IRA container. Visit our UBIT page to see when taxes on IRA earnings may be applicable.
Again, think of an IRA as a tax advantaged investment container. Depending on the type of account either the contributions (money put into the IRA) or distributions (money removed from the IRA) may be taxable.
Traditional IRA contributions are generally tax deductible. The money put inside a Traditional IRA container can reduce your Taxable Income. This is referred to as a ‘Pre-Tax’ contribution. If your taxable income is $50,000, but you make a $3,000 Traditional IRA contribution, your taxable income is now lowered to $47,000. This saves you from paying taxes on the contribution amount.
Withdrawals from Traditional IRAs are taxed at ordinary income rates. Withdrawals made before the IRA holder turns 59 ½ may be subject to a 10% early withdrawal penalty in addition to income tax. Once the IRA holder turns 70 ½, the IRS mandates withdrawals from the account. These are called Required Minimum Distributions (RMDs).
Why use a Traditional IRA? Traditional IRAs can help you reduce your taxable income in current years which will lower tax owed. This is especially helpful if you are in a higher tax bracket. You also benefit from not paying taxes on earnings or interest on the investments while inside the Traditional IRA. You also have more control over when taxes are paid because you determine the timing and amount of distributions (up to age 70 ½).
Roth IRA contributions are not tax deductible. The money put into a Roth IRA container will not further reduce your taxable income. This is referred to as an ‘After-Tax’ contribution. If your taxable income is $50,000 and you make a $3,000 Roth IRA contribution, your taxable income is still $50,000.
Once funds are distributed (withdrawn) from the Roth IRA container they are tax FREE. Withdrawals made before the IRA holder turns 59 ½ may still be subject to a 10% early withdrawal penalty. However, Roth IRAs are not subject to Required Minimum Distributions.
Why use a Roth IRA? While Roth IRAs do not give you an immediate tax benefit, they are highly beneficial as the earnings and distributions are, generally speaking, free of any additional taxes.
Certain withdrawals from Traditional or Roth IRA accounts before age 59 ½ are exempt from the 10% early withdrawal penalty. These include exceptions for first time homebuyers up to $10,000, disability, qualified education expenses, etc.
Additionally, Roth IRA accounts must be open for 5 years before any earnings can be distributed. Earnings taken before the 5 year rule is satisfied will be taxed at ordinary income rates. The cost basis (your total contributions) is always eligible to be withdrawn without penalty.