It's tax season, which means for many investors, it's time to make important financial decisions regarding where to direct funds their retirement funds. For those that don't have employer-sponsored programs like a 401k or pension plan, an individual retirement account allows them to save money for retirement while taking advantage of tax breaks. Individual retirement accounts come in two varieties -- traditional and Roth -- and while both are very similar, they have a couple of distinct differences. Here's a quite breakdown of things to consider.
Timing of Tax Savings
With a traditional IRA, the government allows you to save $5,500 a year ($6,500 if you are 50 or older) without having to pay taxes on it. This allows your money to grow tax-free and not pay any taxes until you withdraw it.
The upfront tax break is not available with a Roth IRA, but all the money in the account, including investment earnings, can be withdrawn tax-free in retirement. If you contribute $100,000 over the life of a Roth IRA and your account grows to $300,000, the additional $200,000 is tax-free.
One of the main advantages of the Roth IRA is that, because you have paid taxes on your contributions, you can withdraw that money anytime from the retirement account tax- and penalty-free, even if you are younger than the government minimum retirement age of 59 1/2. With a traditional IRA, early withdrawals are taxed, and you could face an additional tax penalty of 10 percent if the withdrawal from your retirement account is not for a qualified purpose.
Required Minimum Distributions
Though the government encourages retirement savings in an IRA by offering a tax break, it eventually wants to get the taxes due on the money, which is why it requires you to start withdrawing from a traditional IRA at age 70 1/2. There is a formula that dictates how much you must withdraw, and if you don't do so, you face a 50 percent tax penalty on the amount you should have withdrawn. Required minimum distributions are not required with a Roth IRA, since the contributions to the account have already been taxed.
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