The financial world is complex enough without having to worry about what kind of IRA you want to have; there are 11 of them. Thankfully, the majority of average Americans, men and women alike, tend to gravitate towards just 2: the Roth and the Traditional IRA.
But what’s the difference? What’s the hype all about? Why should you have to boggle your brain with something else? Why can’t there be just one type of IRA?
Think of it this way; variety is the spice of life, and you get to choose when you’d like to pay the taxes on your paprika!
Traditional IRA
Traditional IRA’s are commonly referred to as “the tax-deductible kind”. The money that you deposit into this type of IRA is tax deductible, and any monies that you make on your investment won’t be taxed until you withdraw your funds (tax deferred) many years from now. This type of IRA requires that distributions begin at age 59 ½.
If you take funds out before turning the minimum age, you will be subjected to a 10% penalty for early withdrawal (plus 20% deducted to cover your federal income tax). But, if you use the money for a “qualified higher education expenses”, medical insurance premiums, or use the money to buy your first home (amongst a few other reasons) then the 10% penalty may be waived.
If you choose to go through a bank for your IRA, be on the lookout for CD’s (certificates of deposit) attached to such retirement accounts, as CD’s are a bank product and it’s how they make their money. Be sure to search all options before agreeing to anything, as there’s a great, big world out there beyond the banks.
Roth IRA
The tax breaks on a Roth IRA are quite different than those on a traditional one. There are no tax breaks for those who contribute to Roth IRA’s; you pay all taxes the entire time, straight through on every dime that you put into the account. The difference is that when you take the money out of such a retirement account, you don’t have to pay taxes on it (including any monies that you make on the investment). Yes, it’s true; as long as you follow all of the rules, you will never pay a dime in taxes on your gains!
You do need to have your Roth IRA for at least 5 years and be of retirement age (59 ½) to avoid the 10% penalty. Of course, there are a few ways around paying it. One example is that if you buy your first home, you can take out $10,000. There are a few tax breaks for educational expenses, but if college is your primary focus for opening an IRA, an Educational IRA may be just the ticket.
In a nutshell, the difference between a Traditional and Roth IRA’s: Traditional has the tax deferred option, saving you money when you invest, and a Roth IRA saves you tax money when you withdraw.
