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One popular way to save for retirement is through an individual retirement account, also known as an IRA. To help you understand the basics behind IRAs, including the difference between a Roth and traditional IRA, here are some of the most common terms to know.
To start with a simple definition, an IRA is an account that helps you save for retirement. Many people use IRAs in addition to common employer-sponsored plans, such as 401(k)s, because IRAs offer some unique tax advantages.
Ultimately, opening up an IRA is another way to help you invest for your future. There are two main types of IRAs to choose from: traditional IRAs and Roth IRAs. There are several key differences to each that can influence your choice between the two — and these are outlined below.
In 2021, the IRS set the maximum yearly contribution for both a Roth and traditional IRA at $6,000 for those under 50 years old and $7,000 for those above. Especially for those who may not have access to a 401(k) account, these options can help with retirement planning.
2. Traditional IRA
A traditional IRA is a retirement account where you can put in pre-tax dollars (money that has not been taxed). This gives you some tax benefits upfront, as your income will be taxed without the dollars you put in a traditional IRA. Accordingly, any growth your investments experience won't be taxed until you begin taking funds out of the account.
There are several rules to remember about traditional IRAs, especially regarding withdrawals:
- When you take money out or withdraw funds, you will pay taxes on it (based on your income tax rate at the time).
- In most cases, if you take any funds out of your traditional IRA before you turn 59½, you will pay a 10% penalty fee, in addition to having that income taxed. However, there are a few exceptions to this rule, granted you qualify.
- Traditional IRAs also have required minimum distribution (RMD) rules. Currently, if you turned 70½ in 2020 or later, you must start taking RMDs by April 1 of the year after you reach 72, according to the IRS.
Traditional IRAs tend to be popular with people who don't have employer-sponsored 401(k) plans, as well as those who think they will have a lower income in retirement. If you expect to be earning less after retiring (and be in a lower tax bracket), this could be a good option to consider.
3. Roth IRA
A Roth IRA offers a tax break toward the end — not the beginning — of the time period in which you make contributions.
Here's what to know about Roth IRAs:
- You don't get any tax benefits when you contribute funds to your Roth IRA — the money is considered after-tax dollars.
- The tax advantages typically come into play when you withdraw your funds, as you generally won't have to pay taxes on any funds you take out — as long as you are at least age 59 1/2 and have had the account for at least five years.
- Just like a traditional IRA, the age to withdraw with no penalties is 59½. However, there are some exceptions to the rule that make Roth IRAs a bit more flexible.
- There are no RMDs. You do not have to withdraw funds if you don't need them, so any money left in a Roth IRA can be passed on to your beneficiaries.
Roth IRAs are generally more attractive to people who think they might have a higher income in retirement. This is because any withdrawals from a Roth IRA won't have tax implications, as the taxes have been paid prior to contributing.
When an IRA is tax-deferred, it means the taxes are put off until later. A traditional IRA is tax-deferred because your investments can grow without incurring taxes while in the account. You pay taxes on it when you withdraw the funds.
A rollover is what happens if you move funds from one retirement account to another. For example, if you have an IRA at one bank and decide to move the funds to a new one, you can roll the money over into an IRA at the new bank. Rollovers are not taxed as long as they meet the requirements.
Your contribution is the money you put into your IRA. The IRS puts a maximum contribution limit on IRAs. This amount can change slightly from year to year, so make sure you check regularly. As of 2021, the total contribution limit is set at $6,000 for people under 50 and $7,000 for those who are 50 and older.
7. Disbursements or Withdrawals
These terms often get used interchangeably. Both refer to taking funds (or income) from your account. When you retire and start pulling money from your IRA, that's considered a disbursement or withdrawal. Keep in mind that in most cases, if you take any funds out of your IRA before you turn 59½, you will pay a 10% penalty fee.
With these definitions and insights, you may better understand the particulars of this type of individual retirement account, as well as the difference between a Roth and traditional IRA. As you continue with your retirement planning, it can help to think about how an IRA might benefit you and which option might suit your needs.
If you'd like more information around IRAs or wish for a personalized look at your individual situation, consider reaching out to a financial professional for their expert guidance.