IRA stands for Individual Retirement Account. The name is pretty self-explanatory because it is a retirement account that you contribute to yourself. It’s different than a 401(k) because you employer too can contribute to a 401(k). There are two different types of IRAs: Traditional and Roth. If you qualify, you should always choose Roth over Traditional for various reason that I will cover in this post. With each of these retirement accounts, you can contribute a maximum of $5500 per year up to the age of 50. Once you are 50, you can contribute $6500 per year. The general idea is that you’re not supposed to touch this money (without being penalized) until you are 59.5 years of age. I will explain the advantages and disadvantages of both below.
The primary advantage of choosing Roth over Traditional is Roth’s tax treatment. After age 59.5, you can make tax-free withdrawals from your IRA. This is not the case for Traditional accounts. However, you are not able to deduct your contributions in the year that you make them. Also, you are not required to make withdrawals from a Roth account. If for instance, you receive a pension and don’t need to withdraw from your Roth, you can pass your Roth contributions and earnings on to a beneficiary. However, there are limits. If you file individually and make more than $133,00 (in 2017) a year, you cannot contribute to a Roth. Also, if you are married and file jointly and collectively make more than $196,000 a year, you must contribute to a Traditional IRA. Please do note that these numbers for maximum income do change on a yearly basis.
Similar to Roth IRAs, you are able to make penalty-free withdrawals from your Traditional account at age 59.5. However, you must pay regular income taxes on these withdrawals. The primary advantage, in my opinion, of this account, is that you are able to deduct your contributions in the year that you make them, which is not the case for Roth IRAs. At age 70.5, you must begin making withdrawals from your account, which is not required with a Roth. Also, to add onto that, if you do pass some of your contributions and earnings to a beneficiary, that beneficiary must pay taxes on them.
The most significant difference is the tax-treatment. In a Roth, you can make withdrawals tax-free but with a Traditional, you can deduct your contributions. All in all, you get your break on the back-end with a Roth and on the front-end with Traditional. As I mentioned before, if you qualify, ALWAYS choose Roth because its advantages are greater. I hope you enjoyed and please leave comments, questions, and feedback!