A retirement account is a retirement account, right? They're all the same so it doesn't matter which one you choose, right? Wrong! Straight to personal finance jail, do not pass go, do not collect $200. Or I guess in this case... do not collect retirement?
I kid, I kid. If this is your first time on this blog, I'm Chris and I am a... Sarcastic. I go to Sarcasm Annoymous meetings twice a week and I'm working on myself. But I will keep it under control for the rest of this article I promise.
Ok, on to why you're here. You clicked the title because you wanted to learn the difference between a traditional IRA and a Roth IRA. First of all, I think it's fantastic that you want to educate yourself and I applaud you for taking the initiative to change your financial future. No sarcasm.
Second of all, I'm well versed in investing and I am about to give you the best, simplest explanation you have ever read.
Before we start, a little background on me so you feel more comfortable. I'm 34 years old. I'm retired - all thanks to my investments. I have been investing since I was 20. And I have a background in engineering and finance. I hope that all gives me a bit of credibility. If you want to learn more about me this blog would be the perfect place to start.
Enough about me, let's get started.
What is an IRA?
An individual retirement account (IRA) allows you to save for retirement in a tax-advantaged way. IRAs are one of the most effective ways to invest for the future. Investments held in an IRA can include stocks, bonds, ETFs and mutual funds.
Anyone with earned income can contribute to an IRA. There are yearly contribution limits, however. The contribution limit for 2022 is $6,000 for anyone under 50 years old and $7,000 if you are 50 or older.
All contributions are made with after-tax dollars. The tax benefits are different for each type of IRA and that is actually the big difference.
What is a Traditional IRA?
Contributions to traditional IRAs are tax-deductible. This means however much you contribute in a year you can deduct that same amount on your taxes. So let's say you contribute $5,000 this year. When you file your taxes for 2022 you will be able to deduct that $5,000.
You will, however, have to pay taxes when you withdraw your money in retirement. And that withdrawal will be taxed at your ordinary income tax rate. This means your money grows on a tax-deferred basis. You get the tax benefit upfront but have to pay the taxes later.
What is a Roth IRA?
The opposite is true for Roth IRAs. Contributions are not tax-deductible, but withdrawals are tax-free. This means you will not have to pay any taxes on your investment gains. For most this is the better option.
There is a catch with Roth IRAs though. Unfortunately, there are income limitations for contributing to a Roth. So if you make too much money you won't be eligible. There is a work around this (that is perfectly legal) and we will get into it shortly. First, let's look at the income limits:
*Note - I kept the 2021 limits in because you have until April 15th to contribute to your IRA and count it for 2021. If you weren't able to max out your contribution, you still have time!
What is a Backdoor Roth IRA?
A backdoor Roth IRA is a clever tool for high income earners to circumvent the income limits for a Roth IRA. And like I said earlier, it's completely legal.
Let's say you are single and make $145,000. You make too much to contribute to a Roth IRA, but since traditional IRAs don't have an income limit, you open one and contribute to that. Once you make your contribution, simply roll over your funds to a Roth IRA.
Or if you have an existing IRA, convert your entire traditional IRA to a Roth IRA. And your brokerage will help you do it! It's wild.
When you convert the funds, you will be expected to pay taxes on your contributions as well as any earnings.
Why would you want to do a backdoor Roth IRA? Glad you asked.
First, there are no required minimum distributions (RMDs), meaning you are not required to withdraw a certain amount of money from a retirement plan every year. You can take out as much or as little as you want, when you want.
Second, there are significant tax savings as Roth IRAs are not taxable. People like the idea of no taxes.
Conclusion
Whether it's a traditional IRA or a Roth IRA, the important thing is that you begin investing for your future and retirement. And today you took the first steps to learning what the differences are and which one is best for you. I hope this article helped and you begin investing today. Your future self will thank you.
Thanks for reading and have a great day!
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Disclosures
I am not a licensed financial advisor or financial professional. This is not investing advice. I am simply sharing my research and opinion based on that research. It is very important that you do your own research and make investments based on your own personal circumstances, preferences, goals and risk tolerance.
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