Understanding IRAs: Traditional vs. Roth for Your Financial Future
Making sound financial decisions is crucial, especially when it comes to retirement savings. A common question arises: Should you choose a traditional IRA or a Roth IRA? Let’s explore the features of both to help you decide which might be best for you.
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Exploring the Traditional IRA
A traditional IRA provides an upfront tax deduction for contributions made during the tax year. For instance, if you contribute $5,000 to a traditional IRA this month, you can deduct this amount from your taxable income when filing for 2024, ultimately reducing your tax bill.
You can contribute until the tax-filing deadline for the previous year, allowing a window until April 15, 2025, for 2024 contributions. Just ensure to specify the tax year for each contribution you make.
For 2024 and 2025, the total contribution limit is $7,000, plus a $1,000 catch-up contribution for those aged 50 and over. A 52-year-old, for example, can allocate $3,000 to one IRA and $5,000 to another, within the overall limit.
Key points about traditional IRAs include:
- Funded with pre-tax dollars, allowing tax-deferred growth.
- Required minimum distributions (RMDs) start at age 73.
- Penalty-free withdrawals are allowed after age 59½ and after five years of account ownership.
- Withdrawals are taxed as ordinary income.
- Income limits can restrict high earners from making tax-deductible contributions.
- If you expect lower tax rates in the future, delaying taxes on traditional IRA withdrawals could benefit you.
Understanding the Roth IRA
In contrast, a Roth IRA does not give you a tax break when you contribute. However, when you meet certain conditions, you can withdraw from the account tax-free in the future, which can be significant, especially if your investments grow substantially. For example, Ted Weschler, an investor who works with Warren Buffett, grew his Roth IRA to an impressive $264 million!
Here’s what to know about Roth IRAs:
- They are funded with after-tax dollars, allowing tax-free growth.
- High earners may face income limits for contributions.
- You can convert a traditional IRA to a Roth through a “backdoor” method, enabling high earners to access Roth benefits.
- Like traditional IRAs, penalty-free withdrawals can occur after age 59½ and after five years.
- There’s no penalty for early withdrawal of contributions (not earnings), although it’s generally not advisable.
- There are no mandatory withdrawal requirements, allowing you to leave the account to loved ones or charities.
My Preference for Roth IRAs
While 401(k) plans often limit investment options, IRAs—both traditional and Roth—open up a broader selection of stocks, ETFs, and mutual funds. Today, many 401(k) plans also include Roth options.
The flexibility to choose my investments is a significant advantage of IRAs, particularly Roth IRAs. If my investments flourish, I can withdraw the funds at retirement without paying taxes on the gains.
The table below illustrates potential growth in a Roth IRA with a $7,000 annual contribution, assuming different growth rates:
| $7,000 Invested Annually and Growing for | Growing at 8% | Growing at 10% | Growing at 15% |
|---|---|---|---|
| 10 years | $109,518 | $122,718 | $163,445 |
| 15 years | $205,270 | $244,648 | $383,022 |
| 20 years | $345,960 | $411,018 | $824,671 |
| 25 years | $552,681 | $757,272 | $1,712,984 |
| 30 years | $856,421 | $1,266,604 | $3,499,698 |
| 35 years | $1,302,715 | $2,086,888 | $7,093,420 |
| 40 years | $1,958,467 | $3,407,963 | $14,321,677 |
Data source: Calculations by author.
Choose What’s Right for You
Your individual circumstances may lead you to prefer one type of IRA over the other. Evaluate the advantages and disadvantages of both traditional and Roth IRAs to see which aligns with your retirement goals. Remember, you can also contribute to both types over time.
The key takeaway is to establish a solid retirement plan and persistently save and invest throughout your career.
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