This Wednesday, I discussed what a Roth IRA is. Today we’ll be looking at its sibling, the Traditional IRA.
IRA stands for individual retirement account. It’s a tax-advantaged brokerage account, which means you get certain tax benefits when investing in different assets. This account, like the Roth IRA, is made for saving for retirement, when you no longer have an income. The goal is to add money to an account regularly over the span of your career so you'll have enough to live off in old age. This can be done by simply depositing money (which isn’t advisable, investing in even the lowest return assets, like bonds, can be extremely beneficial in the long term) or by purchasing different assets through the account.
The biggest difference between a Roth IRA and a traditional IRA is the tax timing. With a Roth, you deposit post-tax money, meaning you’ve already paid taxes on the account, and you can enjoy tax-free profits in retirement. With a traditional IRA, you deposit and invest pre-tax money, allowing your money to grow tax-free until you make a withdrawal.
So, what's the benefit to this? First, your contributions (money added to the traditional IRA) are tax-deductible, meaning you could get a partial tax refund. Second, it allows you to put off paying taxes on the profits from your investments until you retire. Why is this good? Well, once you retire, your income goes down drastically. This means the amount of taxes you pay also goes down, which, in turn, means you pay fewer taxes on the money you withdraw. In short, you’ll likely pay less in taxes in retirement than you would have during your normal career, overall saving you money.
There are a few limitations that come with opening an IRA. You can contribute up to $6,000 a year if you're under 50, and up to $7,000 a year if you're over 50. Additionally, if your workplace/employer offers a tax-advantaged account like a 401(k), the amount you are allowed to contribute to the IRA decreases.
You can start withdrawing money from a traditional IRA at age 59 ½. Any withdrawals before that age will be taxed at regular income rates and you'll have to pay a 10% penalty. Essentially, if you withdraw money from this account before 59 1/2, you get punished and have to pay more money to the government.
Furthermore, you have to start withdrawing money from a traditional IRA at age 72. Once you reach this age, you are forced to withdraw a certain amount of money every year from this account. This is called a required minimum deduction. When you withdraw money from a traditional IRA, you are taxed at regular income rates. This means unlike a Roth IRA, your profits will not be tax-free. Additionally, unlike a Roth, anyone can contribute money to a traditional IRA, there is no income maximum.
You might be asking, “Should I open a Roth IRA or a traditional IRA?”. Well, if you expect to make less money in retirement, a traditional IRA is for you. This is because as your income decreases, your tax rates decrease too, so if in retirement you have a lower tax rate, you’ll pay less tax on the money you withdraw from the traditional IRA. If you expect your income to increase in retirement or you expect tax rates to increase overall, a Roth IRA may be a better choice.
A traditional IRA is a great way to save money for retirement while also potentially saving on taxes. Open one with any major brokerage or bank and start investing today!