Choosing between opening a Roth IRA and opening a traditional IRA? It’s a good position to find yourself in. It means you’re saving for retirement and considering your options carefully. Congrats! Of course, it’s possible to have both a Roth and a traditional, but since you can only contribute $5,500 a year to either a Roth or a traditional IRA you might want to choose between the two.
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Roth vs. Traditional IRAs: The Basics
Here’s the deal: Contributions to a traditional IRA are tax-deductible, meaning that every dollar you contribute reduces your taxable income. The exception to this is if your income exceeds IRS limits. In that case, you could contribute to a non-deductible IRA that would still be tax-deferred. Tax deferred? That means that you don’t pay taxes on the money you contribute to a traditional IRA (deductible or non-deductible). The money grows without being taxed until you start taking distributions. Traditional IRAs come with Required Minimum Distrbutions (RMDs) that kick in when you hit age 70.5. You can’t leave the money in the account to grow indefinitely. You also can’t contribute to your traditional IRA after age 70.5.
Roth IRAs, on the other hand, are funded with after-tax dollars. You can’t deduct your contributions. Because you pay taxes when you put money in the account you don’t have to pay taxes when you take the money out, either in retirement or at any time before retirement. Roth IRAs don’t have RMDs so you can take money out only as and when you need it. Here’s another Roth IRA perk: You can continue contributing to a Roth IRA no matter how old you are. Planning on working well into your 70’s? A Roth IRA may be just the retirement account you need.
When deciding between a traditional and a Roth IRA it’s helpful to think about your tax bracket. If you’re just starting out in an entry-level job you’re probably in a low tax bracket now. With any luck you’ll be in a higher tax bracket by the time you retire. You, my friend, are a good candidate for a Roth IRA, which requires you to pay taxes now but not in retirement. Conversely, if you think your tax bracket will be lower in retirement than it is now you should consider a traditional IRA. If that’s your situation, the tax break now is more valuable than a tax break in retirement.
If you already have a 401(k) through your job you’re getting a lot of the benefits of a traditional IRA. Your contributions lower your taxable income and your account grows tax-deferred. Plus, 401(k)s have higher contribution limits than IRAs. So, if you already use a 401(k) you may want to diversify your retirement holdings by opening a Roth IRA on the side. That way, when you hit retirement you’ll have at least one source of tax-free income.
Your Accounts, in Retirement and Beyond
As we mentioned, one of the main advantages of a Roth is that they don’t have RMDs. That means that you never have to tap them if you have other sources of retirement income to support you. For folks with plenty of money who are concerned with estate planning, Roth IRAs have serious appeal. Once you have a Roth IRA you can leave it to your heirs in your will. You can continue contributing to it every year of your life, making it a great way to accrue tax advantages. For example, if you have income or gains from taxable accounts you can use them to fund a Roth IRA.
Think your income disqualifies you from contributing to a Roth IRA? Remember that you can do a “backdoor” Roth conversion. Simply contribute to a non-deductible traditional IRA and then do a rollover from that IRA to a Roth IRA. You’ll have to pay taxes on the money you roll over, but then you’ll be good to go with your Roth IRA. Keep in mind, though, that the Roth IRA backdoor conversion option might not be around forever. Some reformers say it’s a loophole that needs to be closed to keep the wealthiest Americans from accessing it.
Around half of Americans don’t have any retirement accounts to their name. If you’re choosing between a Roth and a traditional IRA you’re in a privileged position. Consider the tax and estate planning implications of deciding between a Roth and a traditional IRA. And remember, any time you open a new investing account you should shop around until you find an account with low fees. Fees eat into the value of your retirement holdings over time. Opt for low fees and you’ll keep more of your hard-earned dollars.
If you’re still stumped about whether a Roth or traditional IRA will be best for you, consider talking to a financial advisor. A matching tool like SmartAsset’s SmartAdvisor can help you find a person to work with to meet your needs. First you’ll answer a series of questions about your situation and goals. Then the program will narrow down your options from thousands of advisors to up to three registered investment advisors who suit your needs. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.
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