First off, CONGRATULATIONS! If you’re asking this question you’re already on your first step to that “Rich Life”. What are IRAs? They’re essentially vehicles for retirement (Individual Retirement Account – IRA). As you’ve noticed there are two kinds: Traditional and Roth.
As the names suggest the Traditional came first and the Roth I believe is more a function of my generation, but now they’re very prevalent. Well what’s the difference? If you assume normal usage of these accounts it boils down to one thing…when you get taxed.
Traditional – Use Pre-Tax income. Get taxed on anything that is withdrawn after you retire.
Skip taxes now. Get taxed on everything later.Roth – Use After-Tax income. Anything you withdraw after you retire is tax free.
Get taxed now. Pay no taxes on everything later.
Here is some math with non-real life numbers for additional visualization.
Traditional –
Today: Income: 60k. Invest 10k into Traditional. Get taxed on 50k. 20% Tax Rate (10k). 40k Income.
Retirement: 10k becomes 100k. Your tax bracket at retirement is 10%. You are taxed 10k and keep 90k.Roth –
Today: Income: 60k. Invest 10k into Roth. Get taxed on 60k. 20% Tax Rate (12k). 38k Income (60k – 12k taxes – 10k Roth)
Retirement: 10k becomes 100k. Your tax bracket at retirement is 10%…it doesn’t matter. You already paid taxes so you keep 100k.
The numbers aren’t realistic, but you get the idea. I really like Roth IRAs if you’re under 35. If you believe in the power of compounding and you have time, Roth is probably for you. It’s because your earnings/growth on your investment is all tax free. The longer you let your money grow the more the earnings you get so that’s why I suggest people start this young. It’s the 2nd thing I would consider for retirement (The first being a 401k match from work, if they offer it. 401ks also nowadays come in the Traditional and Roth flavors. Above rules apply as well). IRAs tend to also have much lower limits than 401ks ($5500 in 2016. Rules different if you’re over 50).
This may or may not apply to you, but another reason why I say do it soon is because Roth IRAs have income limits and people generally make less early (the limits change yearly and are fairly high). For 2016 if your income falls is above $183,000 you can put less as you make more (at $188k you can only put in $2750) until…$193,000 you can’t contribute. If you contribute more than you were supposed to you have to take it out and possibly pay some penalties. It gets a bit messy so be aware if you’re close to this threshold.
You can technically take money out before retirement, but you’ll pay taxes (only applies to Traditional since you paid taxes on the Roth already) AND an additional 10% penalty (Applies to both). Just don’t do it.
There’s a lot more, but this will hopefully get you started in understanding IRAs and which is best for you.
Wow you read to the end. Hit me up on Twitter (or upper right icon) if you’re interested in something more specific or just want to chat. I’m trying to be better about trying it out.