Pioneer Wealth Management Group is a fee-only financial planning firm in Dallas and Austin, TX. Milad Taghehchian, a Certified Financial Planner based in Austin, TX, offered to write for our blog this week.
Contributing to your IRA is one of the most important things you can do for your future. But many people don’t know which one to contribute to, or how they can benefit from choosing between the two options. We will outline the differences and run through a quick comparison of the benefits of each one.
The Difference
The bottom line is this: do you want to defer your tax burden, or face it today? If you meet the criteria, the IRS has provisions that allow you to deduct your contributions to your traditional IRAs from your taxable income – i.e., you “earn” less this year. With traditional IRAs, however, you have to pay taxes on that money when you retire and begin taking it out of that account.
With ROTHs, the contributions do not get deducted from your taxable income. Instead, you pay taxes on that money today. This option makes sense for people that do not earn that much today – they are in low tax brackets and will not be taxed as heavily. As they begin earning more, it might make more sense to put the money in a traditional IRA and defer the taxes until they retire, at which point they’ll likely be in a lower tax bracket. The key here is to try to pay taxes when they’ll be lowest – but timing this can be difficult, as future tax rates are essentially unpredictable. For all we know, they’ll just keep increasing!
Early Withdrawals
Before age 59-1/2, the IRS will charge you 10% to withdraw money from your IRAs. However, the ROTH offers more advantages for people who need to withdraw early. If the money has been in your IRA for at least 5 years, a ROTH will let you take out the principal contributions (not what you’ve earned in interest) without charging you a penalty. Withdrawing the earnings would incur a 10% penalty, however. Remember that a ROTH charges taxes upfront and therefore would not incur any tax liabilities if it’s withdrawn early.
There exist some circumstances under which you can make early withdrawals from both types of IRAs without incurring any penalties. These include paying for higher education expenses and buying a home for the first time, among others. Keep in mind, however, that a traditional IRA will incur taxes at the time of withdrawal – whether early or not!
Required Minimum Distributions
Once you turn 70-1/2, traditional IRAs require that you begin withdrawing money from your account. On the other hand, ROTHs do not have these requirements and therefore allow you to grow your money for as long as you want. This is a better option for people that don’t need the money until later on in retirement, as they’ll be able to grow it for much longer than someone who has to begin making withdrawals at age 70.
Bottom Line
Both types of IRA accounts offer different advantages for different people. In deciding where to put your money, you should consider your future earnings potential and retirement needs. Finally, many people decide to use a mix of both accounts.
If you’re a Texas resident in the Austin or Dallas area, we recommend you visit a fellow fee-only financial planning firm. Check out pioneerwealth.com or call Pioneer Wealth Management Group at 512-334-6800.
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