Both Roth and traditional IRAs offer powerful tax breaks for retirement, but they work in opposite ways. Here is how each account works and how to choose the right one for you.
What an IRA Is
An individual retirement account, or IRA, is a tax-advantaged account you open on your own rather than through an employer. You can open one at most brokerages, banks and robo-advisers, and invest in stocks, bonds, mutual funds and exchange-traded funds.
IRAs are available to anyone with earned income, and to a spouse without earned income through a spousal IRA. That makes them useful for freelancers, workers without an employer plan and people who want to save beyond a 401(k).
The IRS sets an annual contribution limit that applies to all of your IRAs combined, along with an extra catch-up amount for savers age 50 and older. The limits adjust periodically, so check the current figures each year.
The two main types are the traditional IRA and the Roth IRA. Both allow your investments to grow without annual taxes on dividends or gains, but they differ in when you receive the tax benefit and how withdrawals are treated.
Choosing between them comes down to a single question: would you rather pay taxes now or later? Your answer depends on your current income, your expected income in retirement and how much flexibility you want.
How a Traditional IRA Works
With a traditional IRA, contributions may be tax-deductible, lowering your taxable income for the year you contribute. That provides an immediate tax break, which can be especially valuable during your higher-earning years.
Deductibility depends on your income and whether you or your spouse are covered by a workplace retirement plan. If you have a workplace plan and your income exceeds certain limits, the deduction may be reduced or eliminated.
Your investments grow tax-deferred, meaning you pay no taxes while the money stays in the account. When you withdraw funds in retirement, the withdrawals are taxed as ordinary income at whatever rate applies at that time.
Traditional IRAs require you to begin taking required minimum distributions once you reach a certain age set by federal law. These mandatory withdrawals ensure that the government eventually collects taxes on the deferred money.
Withdrawals before age 59 and a half generally trigger income taxes plus a 10 percent penalty, though there are exceptions for certain situations such as a first home purchase, qualified education expenses and some medical costs.
How a Roth IRA Works
Roth IRA contributions are made with after-tax money, so there is no deduction in the year you contribute. The payoff comes later, because qualified withdrawals in retirement, including all of the growth, are completely free of federal income tax.
To make qualified withdrawals of earnings, you generally must be at least 59 and a half and have held a Roth IRA for at least five years. Once you meet those conditions, every dollar you take out is tax-free.
Roth IRAs offer unusual flexibility. You can withdraw your original contributions at any time without taxes or penalties, since you already paid tax on that money, which gives the account a degree of emergency backup value.
Roth IRAs do not require minimum distributions during the lifetime of the original owner. That allows the money to keep growing tax-free for as long as you like and can make the account a powerful tool for leaving assets to heirs.
The main limitation is income. Direct Roth contributions are phased out above certain income levels, though high earners sometimes use a strategy known as a backdoor Roth conversion, which is worth discussing with a tax professional.
Which One Should You Choose?
A Roth IRA often makes sense if you expect to be in a higher tax bracket in retirement than you are today. Younger workers early in their careers frequently fall into this category, since their income is likely to grow over time.
A traditional IRA may be the better choice if you are in a high tax bracket now and expect lower income in retirement. Taking the deduction today saves more in taxes than you are likely to pay on withdrawals later.
If you are unsure about future tax rates, splitting contributions between both types creates tax diversification. Having both taxable and tax-free money in retirement gives you flexibility to manage your tax bill each year.
The flexibility of Roth contributions is another factor. If you value the ability to access your contributions without penalty, the Roth offers a safety valve that a traditional IRA simply does not provide.
Consider your full financial picture as well. If you already have a large traditional 401(k), adding Roth savings can balance future tax exposure, while someone with mostly Roth savings might benefit from traditional contributions.
Getting Started With Your IRA
Choose a provider with low fees, a wide selection of investments and an easy-to-use platform. Many major brokerages offer IRAs with no account fees and commission-free trading on stocks and exchange-traded funds.
Opening an account usually takes just a few minutes online. You will need your Social Security number, employment information and bank account details to fund your first contribution and link transfers.
After you deposit money, remember to invest it. Cash sitting uninvested in an IRA earns little, so choose a target-date fund, a mix of index funds or a robo-adviser portfolio that matches your goals and timeline.
Set up automatic monthly contributions to make saving effortless. Spreading contributions throughout the year also helps smooth out the effects of market ups and downs, a strategy known as dollar-cost averaging.
You can make contributions for a given tax year up until the federal tax filing deadline the following spring. That extra window can be useful if you want to maximize your contributions after seeing your full income for the year.
