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Do you know why some people have to pay taxes when they contribute to their IRA while others have to pay taxes when they make a withdrawal? It all comes down to the type of IRA (individual retirement account) in question – a Roth IRA or a traditional IRA. The reason being is that each type of IRA comes with its own set of rules, rates, tax benefits, and annual contribution limits. Those who have already opened up a traditional IRA do have the option for a Roth IRA conversion if you feel that it is more tailored to your retirement needs. Figuring out the right decision for you regarding a traditional IRA vs. a Roth IRA is essential to planning a comfortable retirement.
ROTH IRA and Traditional IRA Accounts are very Similar but…
In many respects, Roth IRAs are mirror images of traditional IRAs. For instance, while traditional IRAs require that you pay taxes on the money you withdraw, Roth IRAs require that you pay taxes before the money is deposited (the funds come from after-tax income, so you’ve already paid taxes on it when you put it in the account).
Of course, they’re not quite exact opposites. There are some similarities. There are some differences between the two investment options that aren’t perfectly mirrored as well.
With a traditional IRA, you make your contribution with pre-tax dollars. It comes off the top, before the IRS takes their cut. Once your money is in the account, it grows tax-free (the same applies to a Roth IRA). When you make a withdrawal from your traditional IRA, you get the money less taxation, because those haven’t been paid. There are some restrictions on withdrawals. With a traditional IRA, you must start taking distributions at age 70.5. That means you have no choice but to begin depleting that account, whether you need the money or not.
With Roth IRAs, the withdrawal situation is different. There are no required disbursements with these accounts, so if you don’t have an immediate need for the money in that account, you can leave it in place. This allows it to continue growing without any taxes accruing (and if you meet certain requirements, you don’t pay taxes when you withdraw your funds either). Roth IRAs do have some limiting factors, though, namely income limits. With a Roth IRA, single tax filers must have less than $125,000 in adjusted gross income. Married filers (those filing jointly) must have less than $183,000 in adjusted gross income (as a note, these numbers are from 2012, and are subject to change over time).
Should You Get a Roth IRA or Traditional IRA Acccount?
While traditional IRAs and Roth IRAs have many similarities, they’re not the same. The biggest difference is when your tax liability comes – do you prefer to pay taxes before or after? You should also consider what your tax rate would be in retirement – higher or lower than it is currently. If it will be lower (and for most retirees that’s true), then a Roth IRA makes more sense as it limits your tax liability on the back end. If it will be higher, then a traditional IRA may be the better way to go to ensure that you’re paying less to the government. You should also remember that contributions to a traditional IRA could generally be written off both your state and federal taxes, though.
Deciding which type of IRA is right for you is not something to take lightly. If you’re not confident of making the right choice, seek professional advice.