Individual retirement arrangements (IRAs) let you to set aside money for your retirement—for living expenses and to pay for the things you want to do when you enter retirement.
Like other retirement plans, IRAs offer tax advantages—specifically, the potential for tax-deferred or tax-free growth. But in exchange for these tax benefits, there are certain restrictions.
To participate in an IRA, you must earn income, and you can contribute up to the annual limit set by Congress. However, you can't contribute more than you earn. You can put money into your IRA each year you're eligible, even if you are enrolled in an employer-sponsored retirement savings plan.
The confusion about IRAs typically falls in their tax advantages. Consult with your accountant or a financial planner to ensure you select one that’s a fit for your individual needs. Here’s a quick guide to the differences between the two most commonly used.
There are two categories of tax-deferred traditional IRAs: deductible and nondeductible. If you qualify to deduct your contributions, your contributions reduce your taxable income, thereby reducing the income tax you owe. The IRS website has resources to help you figure out which and how much of your contributions are deductible.
Earnings on a traditional IRA are tax-deferred for as long as they stay in your account. When you take money out—which you can do without penalty when you turn 59½, your withdrawal is considered regular income, and you'll owe income tax on the earnings at your current rate. If you deducted your contribution, tax is due on your entire withdrawal. If you didn't, tax is due only on the portion that comes from earnings.
Contributions to a Roth IRA are made with after-tax income, but the earnings are tax-free, and withdrawals are penalty free if your account has been open at least five years. What's more, with a Roth IRA you can continue to contribute to as long as you’re earning income, no matter how old you are. You can pass the entire account on to your beneficiaries with first rights going to your spouse then to your heirs if so indicated. And contribution limits for a Roth are the same as those for a traditional IRA. However, there are income restrictions associated with contributing to a Roth IRA.
So Which IRA is better?
This answer varies from person to person. If you’re eligible to contribute to a deductible, traditional IRA or Roth IRA, here are some points to consider:
- Depending on your income, contributions to a traditional IRA may be tax deductible, which reduces your taxable income each year you contribute. But if you don’t need that tax break now, a Roth IRA could give you tax-free distributions later. Paying taxes on your contribution now means you can withdraw your contributions tax-free as long as your account has been open at least five years and you are 59½ or older.
- If you’re young and likely to be in a higher tax bracket when you retire, then a Roth IRA may make more sense. But, if expect to be in a lower tax bracket after you retire, a traditional IRA is usually the better choice. With a traditional IRA, however, you are required to take the minimum distributions after you reach age 72.
Looking for more? This fast fact sheet can help you during tax planning. Download our IRA Quick Comparison Tool to help you compare.