You probably hear it a lot – Americans aren't saving enough for retirement. So you finally decide to do something about it and open an Individual Retirement Account (IRA).
Now, you have to make a choice between opening a Traditional IRA or a Roth IRA. There are important differences.
A Traditional IRA provides a tax break when you save. Suppose you put away $2000 in a Traditional IRA this year. On your 2016 federal and state tax returns, you get a $2,000 deduction. Better still, you don't pay taxes on capital gains or dividends, as long as the money stays in the account.
However, when you are 70.5 years old, you must begin making withdrawals from the account and the money you withdraw is taxed as ordinary income. If you make a withdrawal before the age of 59.5, you'll pay a 10% penalty on top of the income tax.
Roth contributions not deductible
A Roth IRA's primary difference is the contributions to the account are not tax deductible and the money is not taxed when you pull it out. However, the money the account produces over the years, in the form of capital gains and dividends, is never taxed.
So which is better? Increasingly, financial advisors favor the Roth, but it's going to depend on your individual circumstances.
When the Traditional IRA was established, it was generally accepted that most people would retire when they could start receiving social security. If they had high incomes during their working years, they were in higher tax brackets and those deductible contributions saved them money at tax time each year.
When they started making withdrawals, the reasoning went, they would be in a lower tax bracket and therefore, would pay less tax on their savings.
But people are working longer, and many continue to earn high incomes in retirement, through part-time work and income from businesses and investments. The tax bite on Traditional IRA distributions may be greater than anticipated.
If you own a Roth IRA, your withdrawals are not taxed. True, you passed up a tax deduction for most of your working life, but if your investment of $50,000 has doubled over the years, you have essentially earned $50,000 in tax-free income.
There are also fewer distribution restrictions on a Roth IRA. Generally, you can withdraw money without penalty under age 59.5 if you have owned the account for more than five years.
There are limits to the money you can put into an IRA each year, but the amount is the same for both the Traditional and Roth IRAs. For the 2016 tax year consumers can put in up to $5,500. If you are 50 or older, you can put in $6,500.