As new investors turn to the world of retirement planning, the critical question is always which type of retirement account is the right choice for that individual. When it comes to IRAs (Individual Retirement Accounts), there are two major types: Traditional and Roth. Both have their advantages and disadvantages. Which route any particular investor chooses will depend on that investor’s current financial situation and future financial needs.
Both IRAs are subject to the same annual contribution caps, so how much you can contribute will not factor into your decision. Figuring out which type is right for you requires thinking about when you want to access your money, what you want to use your IRA funds for, and what your marginal tax rates are now and will be in the future.
A traditional IRA is intended to be your source of income during your retirement years. You pay into it now, and withdraw the money only after you reach the designated retirement age. The contributions you make now can be claimed as a tax exemption on your current income tax return. Instead, you will pay income tax on that money decades in the future when you withdraw it.
The downside to a traditional IRA is that the money isn’t easily accessible before a certain age, which is currently set at 59 ½. Before that age, you can only withdraw funds from a traditional IRA for a few very specific purposes, like a first time home purchase up to $10,000, qualified medical expenses, or disability. Withdrawals for any other non-qualified expenses will incur substantial penalties, up to 10%.
Finally, contributions can only be made to a traditional IRA up to the age of 70 ½. At that age you must start taking minimum required withdrawals or pay substantial penalties. If you are already 70 ½, your only choice is a Roth IRA.
Roth IRAs differ from traditional IRAs on when the money in your fund is taxed and when you can access it. Contributions to a Roth IRA cannot be claimed as deductions on your income taxes, so that money is taxed now. For example, an investor with a taxable income of $65,000 who contributes $3,000 to an IRA will be have a taxable income of $62,000 if that contribution was made to a traditional IRA versus $65,000 if that contribution was to a Roth IRA. The Roth IRA offers “tax-free growth” as compared to the “tax-deferred growth” of a traditional IRA.
When you are ready to withdraw your contributions from a Roth IRA, those will always be withdrawn tax-free. You can withdraw your contributions at any time: next week, next year, or any time no matter your age. Also, unlike a traditional IRA, you will never be required to make withdrawals. This flexibility in access to your funds is a key advantage over a traditional IRA.
The Roth IRA also offers the potential that your earnings can be withdrawn tax-free, if those withdrawals fit certain criteria, explained in detail here.
Where a traditional IRA has an age limit, a Roth IRA has income limits. The upper income limit for a Roth IRA is roughly $127,000 for a single filer in 2013 and $188,000 for joint filers. If your income is above the Roth IRA limit, your only choice is a traditional IRA.
If your age and income makes you eligible for either type of IRA, which type of IRA is right for you depends on your current and expected future financial situation.
If you are early in your income-earning years and expect your income to rise later in life, a Roth IRA is a good choice for you because you are in a lower marginal tax bracket now than you expect to be when you withdraw your contributions. If, however, you are a high earner now and expect to be in a lower tax bracket at retirement age, a traditional IRA is the right choice. The goal is to subject your contribution to the lowest possible tax rate.
The other factor to consider is whether you need the flexible access of a Roth IRA or prefer your retirement fund be reserved only for retirement. If you want to be able to draw on your retirement fund before you reach 59 ½ years old, a Roth IRA is the only choice.
Whichever type of IRA you choose, you can still roll over your IRA or open a new IRA later. You can and should reevaluate your IRA positions as your financial situation changes. But you should not defer opening an IRA now out of a concern that your choice might not be best. Either type of IRA is better than none.
John Gower is an analyst for NerdWallet, a personal finance website dedicated to helping you save money with financial tips on everything from the IRAs to 30 year mortgage rates.