Individual retirement accounts can be a great way to save for retirement, but if you're going to open an IRA, you need to know about the two different types of accounts that are available to you.
In this installment of Industry Focus, Motley Fool analyst Gaby Lapera and Director of Investment Planning Dan Caplinger discuss the two main types of retirement accounts: traditional IRAs and Roth IRAs. As Dan and Gaby talk about in this clip, traditional IRAs give you an upfront tax deduction on your contributions, while Roth IRAs don't. However, Roth IRAs are treated as tax-free when you make withdrawals in retirement, giving you a later advantage over the taxable withdrawals that traditional IRAs require.
A transcript follows the video.
This podcast was recorded on Jun. 6, 2016.
Gaby Lapera: Now that we know what an IRA is and who can get one, are there different types of IRAs that we should be aware about?
Dan Caplinger: There are. There are a couple of different kinds of IRAs that are the most common that you're going to run into. One is called the traditional, the other is called the Roth. The traditional has been around for a lot longer, and it's the IRA that more people are most familiar with. With the traditional IRA, you put money into the account. Most people will get an immediate tax break in the form of a deduction for how much they put in. If they put in $1,000 into their traditional IRA, they'll get a $1,000 write-off for their taxable income. That will generate some tax savings right away.
The Roth IRA is a little bit different. With a Roth IRA, you don't get an up-front deduction for the amount that you contribute. But, unlike a traditional IRA, you get a big tax break down the line. With a Roth IRA, when you take money out of it in retirement, it's tax-free. With a traditional IRA, you have to pay taxes on those deferrals that you've been getting the benefit of for all those years and decades. At the end of a traditional IRA, the IRS decides they're going to get their share in the form of taxes. But with a Roth IRA, you don't have that. So the question becomes, what's more valuable to you? That up-front tax break, or the bigger tax break down the road?
Lapera: Right. And, depending on where you are in your life, specifically how much money you're making, it can help you decide which one you should get, a Roth or a traditional.
Caplinger: That's true. The thing to think about is, you're going to take two things. Look at how much you would have to pay in taxes now, and compare that with a guess as to how much you would have to pay in taxes when you retire. That's going to guide your decision.
For most people who are younger, their earnings are a bit lower, their tax bracket is pretty low, it generally makes sense to take advantage of the Roth IRA, because even if you get that tax break, it might not be worth very much to you. It might not be worth anything to you, especially if you're in that baby sitting or lawn mowing situation -- you're not going to be in a situation where tax savings amounts to anything anyway. So, moving your money into a Roth IRA instead of a traditional IRA makes a lot more sense.
If you're in the middle of your career, in your high-earning years, it becomes a little trickier. Often, when you're in the highest income period of your lifetime, it makes more sense to go traditional because the tax write-off you get is worth the most, because you're in the highest tax bracket. The tax savings for that write-off is the biggest it's ever going to be.
Lapera: I really wish you had been around when I was 18, when I opened my first IRA, because when I did, I opened a traditional IRA, because I asked the lady at the bank what kind of IRA I should get and she said, "Oh, definitely a traditional." I said, "What's the difference?" And she said, "It's not important." (laughs)
Caplinger: I'm afraid it is important.
Lapera: It is.
Caplinger: It speaks to the fact that there's a lot of confusion out there, even among financial professionals, as far as the ins and outs of IRAs. It's really important for you to check out reputable sources of information to find out what you need to know to make a smart decision.