You’ve likely been told by now that opening up a Traditional or Roth IRA is a good idea.
But, if you’re like most people, you may not even know where to start or what the differences are between these two popular retirement accounts.
Let’s break it down then, shall we?
At the heart of it, Traditional and Roth are just two different types of IRAs (which stands for Individual Retirement Account). When it comes to funding your retirement savings, it’s important to contribute to your employer-sponsored plan if you have one (such as a 401k, 403b, or pension) and then open an IRA if you have the ability.
Why? Because you’ll be able to contribute even more to your retirement accounts this way AND can take advantage of major tax perks associated with these accounts.
Let’s talk contribution limits.
For the tax year 2021, the most you can contribute to a standard employer-sponsored retirement plan is $19,500. So, if you are looking to contribute more towards your retirement, a great way to do this is with an IRA. By opening an IRA, you can contribute up to $6,000 more each year. That may not seem like much, but trust us, every little bit counts!
So, what about those tax advantages?
A-ha! The most critical part of these plans is that they offer certain tax advantages, depending on what plan you select. If you choose to open a Traditional IRA, you will be able to make contributions to the account using pre-tax dollars which may allow you to deduct your contribution amounts from your tax burden. Essentially, this may reduce your overall taxable income for the year which could mean significant savings!
On the other hand, if you choose to open and contribute to a Roth IRA, those contributions must be made with money that has already been taxed. What this means is that any money you contribute for the year will not be able to be deducted from your overall income, BUT you will not pay any taxes on the money when you withdraw the funds at retirement age.
Put simply: the main differences between a Traditional and Roth IRA come down to how you’d like to be taxed. If you would prefer to delay the tax effect until later on in life, then contributing to a Traditional IRA will be the route to take. If, instead, you anticipate that your tax bracket might be higher later in life, you’d potentially want to pay taxes now on your contributions so that you can withdraw and use all of the funds in the account much later on TAX-FREE!
Are there other differences?
Yes – a Roth IRA has certain income restrictions whereas a Traditional IRA does not. What this means is that to be eligible to open and take advantage of a Roth IRA, you must fall below the income threshold for singles or married couples. To see this year’s eligibility requirements, visit this link!
Can I own and fund both accounts?
While you certainly can, keep in mind that regardless, the maximum contribution amount is still $6,000 per year. So while you may be able to fund both accounts, you can only contribute up to $6,000 between the two of them annually.
Before opening either type of IRA, you’ll want to make sure you’re doing a few things first:
In order of priority, which account should I look to open first?
- Contributing to your employer-sponsored plan enough to take advantage of any potential employer match (aka: free money)
- Establishing and maintaining an emergency fund of at least 3-6 months of your income (so that you don’t have to rely on outside sources or credit cards in case of an emergency)
- Making all of your minimum monthly payments on all other outstanding debts
If, after considering all of your options and honestly assessing your situation, you feel that you might be able to open and contribute to either a Traditional or Roth IRA, we recommend you reach out to a financial professional to help you get set up or else aim to open an account using an online bank/investing option.
Wondering how you can get started? We’re more than happy to help!
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