A sports car and a pickup truck are both vehicles, but they're very different ones. Likewise, a traditional IRA and a Roth IRA are both retirement funding vehicles, but they have many differences of their own. Because the type you choose can have a big impact on how you reach your financial goals, it's important to understand these differences.
Traditional versus Roth
The big difference between the two types of IRAs has to do with when you pay taxes on the money -- either now or when you withdraw it in retirement. There are advantages and considerations to both.
With a traditional IRA, your contributions may be tax-deductible and can grow tax-deferred. This tax deferral allows your assets to potentially grow faster because earnings on your investment inside the traditional IRA aren't taxed until you take distributions. When you retire and start taking your money out, your withdrawals are taxed at whatever your tax rate will be in retirement. Many people anticipate their tax rate in retirement will be lower than their tax rate today, so they find this a benefit. Your current income level will determine how much of your traditional IRA contribution is tax-deducible today.
On the other hand, when you contribute to a Roth IRA, you're using money on which you've already paid taxes. Even though you won't be able to take a current-year tax deduction, the earnings on your investments inside a Roth IRA grow tax-free. Since you've already paid taxes on your contributions, your withdrawals in retirement are not subject to taxes, and qualifying distributions are also tax-free. This can make sense for investors who can afford to sacrifice the deduction today for the prospect of tax-free income in retirement. This future tax-free income in retirement is one reason why a Roth IRA can be most beneficial to younger investors and those who may be in a higher income bracket in retirement. Depending on your current income level, you may not be able to contribute fully or at all to a Roth IRA.
When deciding on an IRA, there's a lot to consider both now and in the future. While some people choose a Roth IRA, others find benefit in a traditional. There's also a third option -- diversifying across both types of IRAs -- that can help you achieve tax flexibility in retirement. You can still open and fund both types of IRAs for the 2013 tax-filing year up until the April 15 deadline. The contribution limit is $5,500, or $6,500 if you are 50 years of age or older.
Take advantage of this little-known tax "loophole"
Recent tax increases have affected nearly every American taxpayer. But with the right planning, you can take steps to take control of your taxes and potentially even lower your tax bill. In our brand-new special report "The IRS Is Daring You to Make This Investment Now!," you'll learn about the simple strategy to take advantage of a little-known IRS rule. Don't miss out on advice that could help you cut taxes for decades to come. Click here to learn more.