Traditional IRA vs. Roth IRA

What are the Differences Between Traditional IRAs and Roth IRAs?

An individual retirement account (IRA) is a type of investment account that can help you save for retirement. There are two main types of IRAs: Traditional IRAs and Roth IRAs. Both types of IRAs have contribution limits, but they differ in terms of how they are taxed.

Taxes and Traditional IRAs

A Traditional IRA allows you to make contributions with money that you can deduct on your tax return. This means that you pay taxes on the money when you withdraw it during retirement. The advantage of a Traditional IRA is that you may be able to lower your taxable income in the year that you make contributions, which could result in a lower tax bill.

For example, let's say that you are in the 25% tax bracket, and you contribute $5,000 to a Traditional IRA in a single year. This contribution may be deductible on your tax return, which means that you could save $1,250 in taxes (25% of $5,000). If you decide to withdraw this money during retirement, you will have to pay taxes on the entire amount at your current tax rate.

Taxes and Roth IRAs

A Roth IRA, on the other hand, is funded with after-tax dollars, meaning you pay taxes on the money before you contribute it to the account. The advantage of a Roth IRA is that you can withdraw your contributions and any earnings tax-free during retirement, as long as you meet certain requirements.

For example, let's say that you are in the 25% tax bracket, and you contribute $5,000 to a Roth IRA in a given year. In this scenario, $5,000 is what remains after taxes have been taken out of earnings of $6,667 ($6,667 x 25% = $1,667; $6,667 - $1,667 = $5,000). When you withdraw this money during retirement, you will not have to pay any additional taxes, as long as you meet the requirements for tax-free withdrawals.

Deciding Whether a Traditional IRA or a Roth IRA is Right for You

Both Traditional and Roth IRAs have their own set of rules and eligibility requirements. For example, Traditional IRAs have income limits for tax deductions and Roth IRAs have income limits for contributions. It's important to consider your individual financial situation and goals when deciding which type of IRA is right for you.

One such major consideration is taxes. If you expect tax rates to increase in the future due to an increase in your wealth or income, or the government raises taxes, a Roth IRA may be more beneficial because you pay taxes only on your initial contributions. Other important considerations include when you plan to retire and the current income tax laws in your state and the state you plan to retire in.

At One Day In July, we work to understand the unique financial objectives of each client to determine which investment vehicles are most appropriate and advantageous.