It’s never too early to consider retirement planning, and for many of us who are still developing our careers, an IRA of some sort is a potent financial instrument in helping ensure a successful retirement. However, IRAs come in several forms and flavors and finding the right one may seem to be a daunting proposal without professional help. In this blog, we’d like to focus on a key choice most of us face: which is best, a traditional IRA or a Roth IRA? The answer is both simple and complex simultaneously and bears professional guidance in determining the answer.
To start with the simple answer: neither a Traditional nor a Roth IRA is best overall. The right choice depends on one’s individual financial situation and the goals you have in mind for your own retirement. This is where some help from an experienced financial advisor might prove useful; they’ll be able to assess your needs, goals, and circumstances and help you select the right IRA. So what distinguishes between Traditional and Roth IRAs?
One of the key strengths of a Traditional IRA is the fact that most contributions are deductible. There are limits of course, but in general, most people may contribute to their Traditional IRA as a tax deduction. There are some rules for how the money must be handled once it’s in the Traditional IRA: the money must remain in the IRA until the investor reaches age 59 ½. At that time, the funds can be withdrawn without penalty (withdrawing prior to age 59 ½ incurs a 10% penalty) but ordinary income taxes must be paid on all withdrawals. Furthermore, when the owner of the IRA reaches the age of 70 ½, minimum annual withdrawals must be made, and ordinary income taxes must be paid on the amount withdrawn from the Traditional IRA. Failure to make the minimal annual withdrawal may result in a tax penalty to the amount of 50% of the funds that should have been withdrawn.
The rules surrounding a Roth IRA are slightly different, and those differences may add up quickly. Right off the bat, a key contrast between Roth IRAs and Traditional IRAs is that contributions to a Roth IRA are not tax-deductible, or to phrase it differently are paid with after-tax dollars. The upside of this is that all relevant taxes have now been paid and subsequent growth and distributions are tax-free. However, there are limits on the size of the annual contributions and no withdrawals can be made without penalty until the funds have been in the IRA account for five years.
This leads us to a final point of difference between Traditional IRAs and Roth IRAs: estate planning. The rules are different in terms of how beneficiaries may take advantage of the IRA in question. When the holder of a Traditional IRA passes away, their spouse inherits the IRA and may use it exactly as the original holder would have. Other beneficiaries, however, must choose between three options; lump sum, lifetime withdrawals, or the entire amount no later than five years following the owner’s death. Roth IRAs function a bit differently, in that assets can be transferred to a beneficiary with the same tax-free status as their owner. However, there is also a limit on the size of the annual contributions and no withdrawals can be made without penalty until the funds have been in the IRA account for five years
So which IRA is right for you? As we’ve shown, that depends greatly on your current financial situation and your long-term goals for your retirement and estate planning. The best course of action for most investors is to consult a financial planner experienced in IRAs and let them guide you to the best choice. By illuminating the blind spots along the way, they’ll help you find the solutions you need to ensure a successful retirement.