Understanding The Difference between The Traditional IRA and The Roth IRA
Many across the web are publishing posts today about Roth IRAs. These posts will be written by people with brilliant financial minds. They will likely give you more information than you could ever need about IRAs. And you will be a much better educated person as a result of readng them. By all means, read these posts - they will surely be very good and well worth your time!
But how many bloggers out there will write a simple, easy to understand post about these two IRA options? That is what I am going to try to do... explain the difference between the Traditional IRA and the Roth IRA in as simple of a format as possible and by using as few words as possible. After all, your time is valuable. So let's begin....
What is an IRA?
An IRA is an acronym for Individual Retirement Account. Basically, it is a retirement savings account that you initiate on your own much like a SIPP pension in the UK (unlike a 401K that is employer initiated). While you have to pay taxes on the pay you actually put in to the IRA (either when you put it in or when you take it out... more on that later), your money is allowed to grow tax free! Because of that, having an IRA is an excellent strategy to help ensure financial security when you retire. There are two main types of IRAs - Traditional and Roth.
The Traditional IRA works like this: you put money into your IRA tax free. That means, you do not have to pay income tax on any money you deposit into an IRA... yet. It is allowed to grow tax free. When you reach retirement age and begin to withdraw your money, you must pay taxes on what you initially put in (but not the growth).
The Roth IRA works like this: you put money into your IRA and pay taxes on it just like all your other income. It is allowed to grow tax free. When you reach retirement age and begin to withdraw your money, you get all your money completely tax free!
Huh? So what's the difference?
Good question. The difference (for this simplified version) is when you pay taxes on the money used to fund your investment. Either you pay upfront or you pay when you collect. The benefit to delaying paying the taxes (Traditional IRA) is, of course, instant gratification in lowering your tax bill when you invest in an IRA. The benefit of paying your taxes upfront (Roth IRA) is that no matter how much money you are earning in retirement and no matter how much the tax laws change (after all, taxes seem to always be on the rise... do you really think that will be changing anytime soon?), you have already paid your dues. You are not going to get hit with a huge tax bill because of the IRA at a time in your life where your income may be less than you have been used to. And if you have planned well for retirement, you won't have to pay a big tax bill on the IRA if your earnings push you into a higher tax bracket!
All things considered, I think the Roth IRA is the best option to consider for most investors. How about you? DO you have any IRs? if so, what kind and why?