The difference between the two retirement accounts and why you need to have one.
When I was in college I took a personal finance class. The professor strongly suggested opening a Roth IRA and never even discussed a Traditional IRA. I’d like to discuss why you need to have one and what the differences are between the two types.
An IRA is an Individual Retirement Account. You make contributions that are capped (right now it’s $5,000 a year) each year into this account. IRA is just the name of the account and you then choose how to invest the money in this account. You can’t touch the money until you are 59.5 years old unless you want to pay a 10% tax penalty. Your portfolio grows tax-free. The difference between tax-free earnings and taxed earnings is astounding, especially as you get to 20+ years of compounding. The ability to grow your investment tax-free allows you to compound money much much faster and can be the difference of hundreds of thousands, even millions of dollars.
The Traditional IRA allows you to take a tax write-off with your contribution. If you were to contribute $5,000 this year you could write that amount off from your taxes. Each contribution you make (contribution limits increase every couple years) will be a tax write-off for you. However, when you begin making withdrawals from this account, you will have to pay taxes on this money at whatever tax bracket you are in. Taxes might be much higher at this point or they might be much lower. There are a lot of variables at play here.
The Roth IRA has you contributing money that you’ve already paid taxes on. So that same contribution of $5,000 this year would have no tax write-off. However, when you begin making withdrawals from this account you won’t have any taxes to pay on this money. If taxes are much higher it won’t affect you at all.
My personal opinion is that if you don’t need the tax write-off and will be fine without it then you should go with the Roth IRA. If you are in a low-income tax bracket you may only end up with a tax savings of $750 or so anyway. I’d rather protect myself from taxes being raised substantially and having to pay 50%+ in taxes on my nest egg.
However, if the tax write-off is money that you need then you should probably take the right now tax savings and open a Traditional IRA. You may even get lucky and tax rates will be lower than present rates when you begin making withdrawals.
Regardless of what option you choose, having an IRA is one of the smartest decisions you can make.
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