There are many investment options when it comes to choosing a retirement investment account.
One of the best ways to contribute is by investing in a 401(k) account, especially if your employer offers a match.
But if that’s not an option, or if you want to save even more, you’ll probably find yourself deciding between a Traditional and a Roth IRA.
Here’s how to determine which one is better for you.
What is an IRA?
An IRA, or Individual Retirement Account, is a tax-advantaged retirement account. This means that the contributions you make are pre-tax and will reduce your taxable income.
You can find an IRA at most major brokerages and banks, including both online and brick-and-mortar financial institutions.
You can save up to $6,000 total in an IRA (either a Roth or a traditional) in 2019 if you’re under 50 years old. If you’re 50 or over, you can save a total of $7,000. This includes a catch-up contribution of $1,000.
But before you invest in either of these accounts, you should know that the tax treatment of Traditional vs. Roth IRAs is different. Review the tax implications and consider your expectations for the future to ensure your money is invested in the right account.
How a Traditional IRA works
A traditional IRA used to be the only kind of IRA and is similar to how most 401(k) contributions work. Both are tax-advantaged accounts.
To better understand what tax-advantaged means, let’s look at an example. Let’s say you make $60,000 per year and contribute $6,000 this year to a traditional IRA. That means your taxable income will be reduced by $5,000, so you’ll only pay income taxes on $54,000.
For a single filer, that would shave about $1,320 off of your tax bill. For a married couple filing a joint tax return, a $6,000 IRA contribution lowers their tax bill by about $720.
There are some cases when a Traditional IRA contribution is not tax-deductible. If you have access to a retirement plan at work, you have to make $64,000 or less to deduct a Traditional IRA contribution. If you don’t have access to an employer’s retirement plan (and your spouse doesn’t either), you can deduct your contribution regardless of your income.
With a Traditional IRA, you will have to pay taxes on withdrawals in the future. That means a traditional IRA is typically best for someone who expects to pay a lower tax rate in the future or who has a shorter time frame for their investments to grow before they begin to withdraw.
How a Roth IRA works
Contributions to a Roth IRA are not tax deductible. This means you must pay taxes on contributions you make this year. But in exchange for paying taxes now, you don’t pay taxes on withdrawals in the future. This means that a Roth IRA is best for someone that has a longer investment horizon where the gains on your contributions can grow tax-free.
Roth IRA accounts have the same contribution limits as Traditional IRA accounts: $6,000 for 2019 (or $7,000 if you are 50 or older).
Income limits do apply for Roth contributions, however. To make the maximum contribution in 2019, a single taxpayer has to earn less than $122,000 and a married couple filing jointly has to earn less than $193,000.
Traditional vs. Roth IRA
There are a few factors to consider when choosing between a Traditional and a Roth IRA:
- Your current income (and eligibility) for each account
- Whether you expect your tax rate to be higher today or in the future (the higher your tax rate is now relative to what you expect it to be in the future, the more attractive a Traditional IRA is)
- The amount of time before you begin withdrawing from your account (the longer you have, the more attractive a Roth IRA is)
- Required minimum distributions
- Estate planning
One of the best parts of an IRA — whether you choose a Roth or a Traditional IRA — is that it is independent of your employer.
An IRA offers a great deal of freedom. The investment decision is totally up to you.
With your IRA brokerage account, you can choose virtually any stock, bond, mutual fund, ETF, or other eligible investment for your account, which offers more control over your portfolio and the fees you pay.
Rollover IRA
A third type of IRA is the Rollover IRA. A Rollover IRA allows you to contribute money “rolled over” from a qualified retirement plan into a Traditional IRA account. Rollovers involve moving eligible assets from an employer-sponsored plan, such as a 401(k) or 403(b), into an IRA.
For further reading, you can also review the difference between a Traditional IRA and a Roth IRA.