An individual retirement account, or IRA, is one of the most powerful tools available for building retirement savings. Whether or not you have a workplace plan such as a 401(k), an IRA lets you invest for the future with valuable tax advantages. The two main types, the traditional IRA and the Roth IRA, both offer tax benefits, but they deliver them at different times. Understanding that difference is the key to choosing the right account.
With a traditional IRA, contributions may be tax-deductible in the year you make them, depending on your income and whether you or your spouse are covered by a workplace retirement plan. Your investments grow tax-deferred, meaning you do not pay tax on dividends or gains each year. When you withdraw money in retirement, those withdrawals are taxed as ordinary income.
How the Roth IRA is different
A Roth IRA works in reverse. Contributions are made with money you have already paid tax on, so there is no upfront deduction. In exchange, your investments grow tax-free, and qualified withdrawals in retirement are completely free of federal income tax. You can also withdraw your original contributions at any time without tax or penalty, which gives a Roth IRA added flexibility.
Roth IRAs have income limits, so higher earners may be unable to contribute directly. Traditional IRAs have no income limit for contributions, although the deduction may be reduced at higher incomes. Traditional IRAs also require minimum distributions starting at a certain age, while Roth IRAs have no required distributions during the original owner's lifetime, which can be valuable for estate planning.
The real question is simple: would you rather pay tax on your savings now, or later?
Which account should you choose?
A Roth IRA is often attractive if you expect to be in a higher tax bracket in retirement than you are today. This frequently applies to younger savers early in their careers, whose income is likely to grow. Paying tax now at a lower rate and enjoying tax-free withdrawals later can produce significant long-term savings.
A traditional IRA may be the better fit if you are in a high tax bracket now and expect a lower bracket in retirement. The upfront deduction reduces your current tax bill, and you may pay less tax on withdrawals later. Many savers choose to use both types of accounts, creating tax diversification that gives them more flexibility to manage their taxable income in retirement.
Whichever account you choose, the most important step is to start contributing consistently. Annual contribution limits apply across all of your IRAs combined, and contributions for a given year can usually be made up until the tax filing deadline. Investing within the account in a diversified mix of funds suited to your time horizon helps your savings grow over the long term.
The wealth and investment planning team at Native Finance Expert can review your income, goals and current accounts and recommend the right IRA strategy for you. Contact us for a free retirement planning consultation.