When planning your finances for the future, many might consider the wisdom of investing in an Individual Retirement Account, commonly called an IRA. While some might choose a traditional IRA, for which you will only pay taxes on the distributions, others might prefer a Roth IRA. These IRAs require you to pay taxes upfront on your contributions.
However, you will not need to pay taxes once you are ready to withdraw the funds from your account.
An investment account for your retirement is one of the top priorities for those looking to save and invest. Choosing between a Roth IRA and a traditional IRA can be difficult, especially if you do not know must about them. Many people might recommend a Roth IRA as the better option, but it is important to consider both the advantages and disadvantages of this type of investment first. Before making a decision that could affect your financial future, take an objective look at whether a Roth IRA is the best choice for you.
Tax Benefits
One of the biggest draws of a Roth IRA is the fact that you do not have to pay taxes on your distributions. By paying the taxes on your contributions upfront, you can save yourself the trouble and expense of paying additional taxes on these funds once you need them. This means you do not have to pay taxes on the growth of the account either.
The Roth IRA could be the best option for those who have moved to a higher tax bracket by the age of retirement. If you paid the taxes on your contributions while in a lower tax bracket, you will not be charged additional taxes once you start receiving distributions.
If you have more than one account in which you are investing for retirement, a Roth IRA can provide you with some diversification for your taxes. This can help to control the amount of tax you pay once in retirement, as you can balance the distributions you receive from each source.
Tax Disadvantages
The downside to the tax structure of a Roth IRA means you will pay more on your taxes upfront, which can add significantly to your current expenses. For those who have a lower income, it could prove more difficult to meet the tax requirements of a Roth IRA now, rather than to meet the requirements of a traditional IRA in the future.
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Even if the idea of tax-free distributions in retirement sounds ideal, being able to afford the tax as you pay your contributions is crucial. It is also worth noting that the amount by which your account grows may not be significant enough to impact your future tax payments by much. In this case, a traditional IRA can be just as useful.
No Age Restriction
A traditional IRA has an age limit, which prevents you from contributing to the account six months after you turn 70. If you plan to keep working later in life, this can be an issue. In addition to this, you must begin to take distributions from a traditional IRA once you reach this age. If you have another income at that time, this requirement may push you into a higher tax bracket.
A Roth IRA does not have these restrictions. You can continue to contribute well past 70 years of age, and there are no minimum distribution requirements to follow.
Limitations
Similar to 401(k)s, there are limitations on the contributions you can make to a Roth IRA, which some may find overly restrictive. You can only contribute a certain amount each year, and going over the maximum limit means you could be fined.
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In addition to the restrictions placed on your contribution, your eligibility may also be limited. Your income will be considered, as well as the income of your spouse, when determining whether you can open a Roth IRA.
Withdrawals
Some investors may be worried about putting their money in a long term account, as they want to have access to it in case of an emergency. If this is a concern for you, a Roth IRA could be the better investment option. You are permitted to withdraw money from the account with relative ease, and without hefty fines or penalties.
These withdrawals are limited, as you should only withdraw the funds you contributed directly, rather than investment growth or funds you converted from a traditional IRA. However, this additional accessibility means a Roth IRA can also function as an emergency fund, rather than only serving to plan for your retirement.
Uncertain Future
There are areas of uncertainty that could affect your decision to use a Roth IRA. The success of any retirement plan depends on uncertain factors, as you are providing for the future. However, when planning ahead for the use of a Roth IRA, consider the following:
- Your tax bracket may be low now, and you might plan to take advantage of this by paying a lower tax amount on your contributions. If you are in a higher tax bracket at the time of retirement, this means you have saved money. However, there is no way to guarantee that you will move to a higher tax bracket. Your income may grow, but not enough to move you to a higher bracket, negating the effect of paying your taxes now.
- The rules regarding Roth IRAs may change. It may be many years before you use the money in your account. If the rules governing Roth IRA contributions or distributions change during this time, you may lose out.
Conversions
If you are unsure as to whether you want a Roth IRA, remember that you may be able to convert a traditional IRA into a Roth IRA. This can be a good solution if you are concerned about Roth IRA income limits, as there is no restriction on the amount you convert.
You will have to pay taxes on the full amount before converting it, including any investment growth. You must also pay to cash out the IRA, and taking the money out could place you in a higher tax bracket. However, if it is feasible for you, this option may be preferred.
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