Hi, I'm Candace
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A question we hear all the time is “Should I invest into a Traditional IRA or a Roth IRA?“. What’s the difference between the two? Is one better than the other? Hopefully this post will clear up the mystery!
The “best” IRA is the account that leaves you with the most money in retirement. So which one is the best for you? That depends on many factors, including your age, salary, and current & future tax bracket.
Traditional: You contribute pre-tax money (meaning the money you contribute does not count as taxable income… so you’re getting a tax deduction for your contributions in the year you contribute). The money grows tax-free. When you withdraw the money in retirement it is taxed at your ordinary income tax rate for that year.
Roth: You contribute after-tax money (so money you’ve saved after receiving your paycheck, which has already been taxed). The money grows tax-free and is not taxed when you withdraw it in retirement.
Why does it matter whether your money is taxed before or after going into your account?? Because your tax bracket can vary significantly year to year.
The general rule of thumb is if you expect your tax rate to stay the same or rise in retirement, then a Roth account may be better for you.
Generally, if you are a young worker in the early part of your career, the advantage tips to Roth, because your salary is likely relatively lower than it potentially will be later in your career or in retirement.
Example: Let’s say you’re single, earning $50,000 this year. Your marginal tax rate will be 22% in 2022.
Suppose you retire 40 years from now. Let’s assume you’re still single but even in retirement your annual income has climbed to $125,000. If the government does not change today’s tax rates, your rate will be 24%.
So you’re better off paying just 22% on your income today than paying 24% when you retire. That means you’re better off with a Roth IRA — or a Roth-style 401(k) account, if your employer offers them — than with traditional versions of those same accounts.
On the other hand, if you’re not new to the workforce and don’t have many years left until retirement, or if you plan on making less income in retirement, than a traditional IRA or 401(k) may be more beneficial to you.
Example: Let’s say you plan to not work during retirement and rely on passive streams of income and your retirement savings account. If those projected streams of income are less than your current annual income, then it would be most beneficial for you to invest in a traditional IRA.
With a traditional IRA and any 401(k) plan, you must start taking withdrawals by April 1st of the year you turn 70 1/2. Roth IRA’s are exempt from required minimum distributions.
You can only withdraw money from a traditional IRA penalty-free if you’re over age 59 1/2 and your account has been open five years or more. However, you can withdraw your Roth contributions (not your earnings) at any time penalty-free!
Candace is the founder of NewWay Accounting and is a CPA who specializes in working with fellow entrepreneurs. She strives to take the fear and anxiety out of taxes and help empower small business owners to feel more confident and in control of their finances.
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