Traditional IRAs and Roth IRAs are two of the most advantageous types of accounts for saving money for retirement. While very similar, there are some key differences between these two types of retirement accounts. Everyone needs to know about traditional IRAs and Roth IRAs to decide which one is right.
In a traditional IRA, account holders can deduct contributions from their annual taxable income for both federal and state returns. This means that they are not taxed on money contributed to a traditional IRA in the year it is earned. When it’s time to take distributions from the IRA, however, the contributor will have to pay the appropriate tax based on their income level. Essentially, this makes contributions to a traditional IRA tax-deferred since taxes must eventually be paid on money received from the account.
A Roth IRA works in the opposite way to a traditional IRA. In a Roth, contributions are made on a post-tax basis. Contributors are still taxed on the money they pay in, negating the immediate tax advantage of a traditional account. The power of a Roth IRA, however, is in the long run. With a Roth, capital gains are not subject to tax. This means that when the contributor retires, they are not taxed on withdrawals from the account.
In addition to this key difference, some minor differences separate traditional and Roth IRAs. To begin with, there are income caps on Roth IRAs. Individuals making $144,000 or more cannot contribute to a Roth IRA. Contribution limits are also lowered for individuals making more than $130,500.
Roth IRAs also do not come with required minimum distributions. In a traditional IRA, contributors must take distributions beginning at age 72. This requirement isn’t placed on Roth IRAs.
A final key difference between the two types of accounts is that Roth IRAs can be left to beneficiaries tax-free. As with the contributor, a person who inherits a Roth IRA does not have to pay taxes on withdrawals. This makes Roth IRAs suitable as vehicles for transferring wealth to children or grandchildren.