How Is an IRA Different From a Roth IRA: Why Does It Matter?
You want to retire in roughly 10 years, but your retirement savings are not what they should be.
In this, your final decade of full employment, it is vital that you contribute as much money as possible to an individual retirement account (IRA). But which kind? Perhaps a traditional IRA that can help you lower your income taxes. Or maybe a Roth IRA that offers long-term flexibility is a better choice.
Both the IRA and the Roth IRA offer unique investment benefits, though some may be more valuable to individuals who plan to retire within the next few years. Before committing to one account type or the other, carefully consider the tax, investment and redemption advantages—and disadvantages—of each.
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What is an IRA?
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In 1974, Congress created the individual retirement account, an investment account that offered those who were not part of a pension plan a convenient way to lower their taxable income, while saving for retirement. The idea was that working taxpayers could contribute up to $1,500 into an invested or interest-bearing account, but pay no taxes on that $1,500 until years later when they retired. Over the years, the maximum annual contribution has increased several times. Today, individuals may contribute up to $5,000 per year. Those 50 years of age and older can make an additional $1,000 “catch-up” contribution, for a total of $6,000 per year.
Traditional IRAs: Tax Considerations
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With a traditional IRA, your contributions and the interest they earn are not taxed until you begin making withdrawals, which you must do by age 70.5 (but not before age 59.5). So, for example, if you earn $60,000 per year, and you contribute $5,000 of that to an IRA, you will only pay income taxes that year on $55,000. Each year until retirement, your money will grow through yearly contributions and through interest. In retirement, the withdrawals you make will be taxed as ordinary income.
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Roth IRAs: Tax Considerations
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In 1997 Congress created the Roth IRA, a different breed of retirement account designed specifically to benefit middle-class taxpayers. Unlike with traditional IRAs, contributions made to Roth IRAs are made with money that has been taxed. The advantage comes at retirement: The money in your Roth IRA—including any investment earnings—are not taxed when you withdraw it. Furthermore, there are no age limits for withdrawals and no restrictions on how, when or why you make a withdrawal. For an individual who has contributed to a Roth IRA, and invested the funds in the account wisely, the advantages of this type of account can be significant.
Crunch the Numbers: Traditional vs. Roth
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If you have 10 years to save for retirement, consider this: Income tax rates are currently at historic lows. Given the enormous budget deficits that the federal government currently runs, it seems highly unlikely that income tax rates will remain at these levels for another 10 years. Therefore, if you contribute the maximum allowable amount annually to a Roth IRA, for the next few years at least, you will pay historically low taxes on the front end, and then accumulate wealth tax free. If you contribute the same amount to a traditional IRA, you could lower your taxable income right now, but in 10 years, you will probably pay higher taxes on any and all money you withdraw.
Clearly, with 10 year's left until retirement, the Roth IRA is the best option for you.
Rolling Your Current IRA into a Roth
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Let’s say you are in your 50s and you already have a traditional IRA. You read this article and, concerned about future changes to tax policy, you wonder if you should roll your traditional IRA into a Roth IRA. The answer is an emphatic NO! Remember, only taxed money may be contributed into a Roth IRA. Were you to initiate such a rollover, all your contributions and earnings would be taxed, leaving you only 10 short years to recoup them through investing your Roth IRA funds. Stay the course. You will actually come out better building your current account through contributions and wise investing.
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