Should You Get A Traditional IRA Or A Roth IRA?

retirement traditional IRA or a Roth IRA

There are tremendous benefits to working for yourself. You get to do just about everything on your own terms, and you don’t spend your life making money for someone else. However, you do miss out on a number of benefits of employment. One of the major benefits of employment is not having to deal with your retirement fund yourself.

Most employers will give you a traditional 401(k), which is grown through deductions to your untaxed income. There are people who will ask their employers for a different kind of retirement fund, but the majority are happy with a 401(k).

When you are self-employed, you need to sort out your own individual retirement annuity (IRA). This requires some understanding of how a traditional IRA works. While you can go with a traditional IRA, there are benefits to converting to a Roth IRA. A Roth IRA has some key differences, and your choice should be based on your individual circumstances.

To help you decide whether to get a traditional IRA or a Roth IRA, here is what you need to know about each type of plan.

What is a Traditional IRA?

Traditional IRAs work in a similar fashion to traditional 401(k)s. Deductions are made on your income before tax. In other words, your deductions are not taxed and the amount of money taxed is smaller. Although this means your retirement funds will be taxed upon withdrawal at retirement age, there are tax benefits to this.

In some cases, deduction of your retirement contributions will leave you in a lower tax bracket and you will pay less income tax every year. Even when this is not the case, deducting retirement contributions before tax means you have more money to spend during your working years. Furthermore, your IRA grows with compound interest that is higher, because the funds are not minimized by taxes.

When you withdraw your funds at retirement age, you will be taxed based on your tax bracket at that stage. If you expect your tax bracket then to be lower than it is now, you will certainly benefit from having delayed your taxes.

There are certain restrictions placed on traditional IRAs. The most significant relate to withdrawals. You cannot simply leave your funds in your IRA after retirement age, but will have to take required minimum distributions (RMDs) from the age of 72.

Now, let’s look at how a Roth IRA differs.

What is a Roth IRA?

The Roth IRA came into existence as an alternative to the traditional IRA, in a bill sponsored by Senator William Roth. Unlike a traditional IRA, a Roth IRA collects deductions only after tax. Because of this, when you withdraw your funds at retirement age, you do not have to pay any tax.

What are the benefits of having your deductions taxed? One benefit is simply the peace of mind that you will not have to pay tax upon retirement. But the benefits go further than this. If you expect to be in a higher tax bracket at retirement age, you will not have to pay the higher taxes.

Roth IRAs work more like traditional investment accounts. In addition to being paid after taxes, there are fewer restrictions. While withdrawing your traditional IRA early will lead to penalties (and the amount will be taxed), you can withdraw sums equivalent to your Roth IRA contributions at any time, without being taxed.

You can also leave your Roth IRA untouched after retirement. There are no RMDs, and you can leave it as a fund for the beneficiaries of your estate after your death. If you are working on building generational wealth, a Roth IRA is an additional source of funds that will serve your children and grandchildren.

Traditional IRA vs Roth IRA

There is no right answer as to which IRA you should choose. Your decision should ultimately come down to your personal circumstances and how you expect your future earnings to play out. Most people expect their gross earnings to decrease after retirement, but for some people that is exactly when other investments will start to pay dividends, and paying taxes on retirement funds then will be more expensive.

You cannot guarantee how your career will play out, and you have to make decisions based on the most likely scenario. Choose the type of IRA that likely suits you both now and in the future. If you do decide on a traditional IRA, you can always convert it to a Roth IRA at a later date, without penalties or major hassle.