We have already discussed what an IRA is in a separate article. So what is the difference between the two main types of IRAs?
What is a Roth IRA?
In a Roth IRA, you contribute money on a post-tax basis and withdraw it tax free in the future. In other words, you contribute money that you have already paid income taxes on. Since you have already paid taxes on the money you put into the Roth IRA, the IRS lets you remove it from the Roth IRA in the future without paying more taxes.
All the growth in investments in a Roth IRA is untaxed when it is withdrawn after age 59 ½. That is, you do not need to pay income taxes on withdrawals from a Roth IRA in retirement.
Let’s take an example:
- You invest $3,000 in post-tax money in a small company through your Roth IRA at age 25
- Over the next 40 years, that stock increases in value by 10% per year until you sell the stock at age 65
- That investment will be worth almost $136,000 when you sell
- You can withdraw that entire $136,000 when you sell without paying any taxes
Roth IRAs have an income limit, so you cannot contribute additional money to a Roth IRA if your taxable income (MAGI) is above a certain threshold ($144,000 for single filers in 2022).
What is a traditional IRA?
Money in a traditional IRA money is contributed on a pre-tax basis. You have not paid income taxes on the money that you contribute. Instead, you pay taxes on the full value of your investment when you remove money from your traditional IRA in retirement.
Let’s take the same example from above and make a few changes:
- You invest $3,000 in pre-tax money in a small company through your traditional IRA at age 25
- Over the next 40 years, that stock increases in value by 10% per year until you sell the stock at age 65
- That investment will be worth almost $136,000 when you sell
- When you withdraw that money from your traditional IRA, you will owe income taxes on all money coming out of the IRA
Should I use a Roth or Traditional IRA?
Everyone has a different financial situation so there is no single correct answer. Based on your specific circumstances, it may be beneficial to use one or the other.
As you can see, the big difference between a Roth and traditional IRA is when you pay income taxes. With a Roth IRA, you pay the taxes up front. With a traditional IRA, you pay the taxes in the future. This means there are three possibilities that can impact your decision:
- If you think that your tax rate will be higher in the future, it would be beneficial to pay the lower tax rate now by using a Roth IRA. Then you will avoid higher tax rates in the future when you withdraw your money
- If you think that your tax rate will be lower in the future, it would be beneficial to pay the lower tax rate in the future by using a traditional IRA. Then you will avoid higher current tax rates and defer payment into the future
- If you think your tax rate will be the same in the future, whether you use a Roth or traditional IRA will not make a difference in your spending power in retirement
