The question inevitably comes up – Which Type of IRA Should I Invest In?
It’s a good question, and there are advantages and disadvantages of both the Traditional IRA and the Roth IRA. So let’s take a look at both and try to determine which IRA is best for you.
Let’s start with the Traditional IRA. This is simply an Individual Retirement Arrangement (IRA) that allows you to put money in pre-tax.
In other words, you can take a deduction on your taxes for your contributions (as long as you are not covered by a retirement plan through work, and don’t make too much).
Advantages of a Traditional IRA
There are two main advantages to a Traditional IRA:
- You can (possibly) get a deduction on your income, which reduces your tax liability now.
- Your contributions grow tax-deferred — no taxes to pay on any gains or contributions until you withdraw.
Disadvantages of a Traditional IRA
There are also some things to be wary of:
- If you withdraw your IRA before age 59 1/2, you’ll have to pay taxes AND a 10% penalty! (unless you meet one of the exceptions)
- As noted above, you may not qualify for a pre-tax deduction on your IRA if you are covered by an employer-sponsored retirement plan and you make too much money! The income limit is $55,000 – $65,000 for single filers and $89,000 – $109,000 for joint filers.
- You MUST begin withdrawing your IRA by age 70 1/2. If you don’t – you’ll get whacked with a 50% penalty.
So, a Traditional IRA is a good retirement vehicle, but just like any account there are some negatives as well.
And then there is the good ol’ Roth IRA. The account that many people are still unsure how it works, which is surprising to me since they’ve been around for 10 years.
A Roth IRA is simply an IRA that is funded with after-tax contributions and grows tax-deferred.
Advantages of the Roth IRA
- Earnings grow tax-deferred.
- Withdrawals are completely tax-free after age 59 1/2.
- You do not have to pull your money out at age 70 1/2.
- You can withdraw your contributions at any point in time (since they are after-tax, there are no tax consequences) without penalty.
And as with all accounts there are some things to be aware of:
Disadvantages of the Roth IRA
- You do not get a tax deduction now. No tax break! That’s a big one.
- If you make too much, you get phased out of contributions to Roths. The income limits in 2010 are $105,000 – $120,000 for single filers and $167,000 to $177,000 for joint filers.
- You have to leave the account open for at least five years before you get to pull money out tax-free – that is if you are over 59 1/2 anyway.
Which IRA Is Right for You?
Ok, so there you have it. The advantages and disadvantages of both Roth IRAs and Traditional IRAs.
Now to the question at hand – which IRA should you invest in? Those who know me will know the answer already – it depends.
Looking at the advantages and disadvantages above you’d think the Roth IRA is the winner hands down, but it’s more complicated than that.
I’m a big believer in tax diversification, so at the very least you should be spreading things around a bit when it comes to your tax liability.
That may mean if you’re investing heavily into a 401k that you start funding a Roth, or if you’ve completely ignored your 401k and solely invested into the Roth that you may need to start that 401k up!
But the broader question will be, which IRA provides me with the best tax savings. That’s the question we all want to know.
For that you may want to check out a Traditional vs Roth IRA calculator to determine for yourself which is best.
Generally speaking you can’t go wrong with either one, just make sure you know the rules and save consisently!
What About You?
Readers, which IRA do you like better and why?
Photo by scottwills