The Difference of Roth IRA vs. Traditional IRA
Not everyone has access to a retirement plan through work. Even if your employer offers a 401(k), you may eventually want to save additional money for retirement on your own.
One of the most common ways to do that is through an Individual Retirement Account, usually called an IRA.
An IRA is different from a 401(k) because you open it yourself rather than receiving it through an employer. You can keep the account when you change jobs, and you choose the financial institution where you open it.
There are two main types most people encounter: the Traditional IRA and the Roth IRA. Both are designed for retirement savings, but they handle taxes differently.
Understanding how they work can help you recognize whether an IRA makes sense for your financial situation.
What Is an IRA?
An Individual Retirement Account (IRA) is a retirement account that you open yourself through a financial institution. Depending on the provider, this might be a brokerage firm, bank, credit union, or investment company.
Unlike a 401(k), your IRA is not connected to your employer. You can have the same IRA throughout your career even if you change jobs several times.
An important detail is that an IRA is an account, not an investment.
Think of the IRA as the container. Once you put money into it, you still need to decide how that money will be invested from the choices available through your provider. Those choices might include mutual funds, index funds, exchange-traded funds, bonds, stocks, or other investments.
This is an easy detail to miss when opening your first account. You can successfully open an IRA, transfer money into it, and still have that money sitting in the account without being invested.
You also do not have to choose between an IRA and a workplace retirement plan. Someone could contribute to a 401(k) through work and also contribute to an IRA on their own, as long as they meet the applicable rules and limits.
Traditional IRA vs. Roth IRA
The biggest difference between a Traditional IRA and a Roth IRA is when you receive the tax benefit.
With a Traditional IRA, your contribution may be tax-deductible depending on your income, filing status, and whether you have access to a retirement plan at work. The money can grow in the account without you generally paying taxes on investment gains each year. When you take taxable withdrawals later, they are generally treated as income.
With a Roth IRA, you contribute money after taxes. You generally do not receive a tax deduction for the contribution today, but qualified withdrawals later can generally be taken tax-free.
A simple way to remember the basic difference is:
Traditional IRA: Potential tax benefit now, taxes generally paid on withdrawals later.
Roth IRA: Taxes paid before the money goes in, qualified withdrawals generally tax-free later.
For example, someone early in their career may prefer a Roth IRA because they are currently earning a relatively modest income and like the idea of paying today's tax rate rather than paying taxes on qualified withdrawals in retirement. Someone else may place more value on the potential tax deduction available with a Traditional IRA.
Your income and tax situation matter, so there is no universal answer.
How Much Can You Contribute?
The IRS sets annual contribution limits for IRAs, and those limits can change over time. There are also additional rules for people who are age 50 or older.
One detail that is particularly important: the annual limit generally applies to your combined contributions to your Traditional and Roth IRAs.
For example, if the annual limit is $7,000 and you put $4,000 into a Roth IRA, you generally cannot then put another $7,000 into a Traditional IRA. You would have $3,000 of remaining contribution room for the year, assuming you otherwise qualify to contribute.
Roth IRAs also have income-based eligibility rules. Depending on your income and tax filing status, the amount you can contribute directly to a Roth IRA may be reduced or you may not be eligible to make a direct contribution.
Because these rules and limits can change, check the current IRS requirements before making a large contribution.
You also do not need to start with a huge amount of money. If your financial institution allows it, you might contribute $25, $50, or another amount that fits your budget and increase it later.
The important part is understanding the rules before you contribute.
Opening and Using an IRA
Opening an IRA is generally straightforward. You choose a financial institution, select the type of IRA you want, provide the requested information, and fund the account.
After that comes the part that deserves a little more attention: choosing your investments.
Suppose you open a Roth IRA and deposit $1,000. The $1,000 is now inside your Roth IRA, but that does not tell you what the money is actually invested in. You may need to select an investment from the options offered by your financial institution.
Some people choose diversified funds, such as index funds or target-date funds, while others choose different combinations of investments. The choices available and the fees charged can vary between financial institutions.
You can also automate contributions. For example, you might arrange for $50 to be transferred into your IRA every payday. That can make saving more consistent because you do not have to remember to make the contribution manually each time.
An IRA is also portable. If you change jobs, your IRA stays yours. If you have retirement money in an old 401(k), you may also have the option of rolling that money into an IRA, although rollovers have specific tax rules and should be handled carefully.
Using Retirement Money Early
IRAs are designed to help you save for retirement, so taking money out early can come with tax consequences.
Traditional and Roth IRAs have different withdrawal rules, and there are exceptions that can allow certain withdrawals without the usual early-withdrawal penalty. The rules can become complicated depending on the type of contribution, your age, and the reason for the withdrawal.
For that reason, it is worth understanding the consequences before treating an IRA like an emergency savings account.
This is also why retirement savings should fit into your larger financial picture.
If you are currently trying to keep up with rent, groceries, transportation, or high-interest debt, you may not have much available to put toward retirement. You can still learn how IRAs work now and use that knowledge when your financial situation gives you more room.
You might start contributing $25 a month, increase it after a raise, or wait until you have established some basic financial stability. Your retirement strategy can change as your life changes.
The important thing is knowing what options are available to you.
Final Thoughts
An IRA gives you another way to save and invest for retirement outside of your workplace retirement plan. A Traditional IRA and a Roth IRA both offer tax advantages, but they provide those advantages at different points in the process.
Before opening one, understand the tax treatment, contribution rules, investment choices, and withdrawal rules. And once you open one, remember that depositing money is only part of the process. You also need to decide how that money will be invested.
You may not be ready to contribute much right now. That's okay. Learning how these accounts work gives you information you can use later, whether you eventually contribute through a workplace 401(k), an IRA, both, or another retirement strategy.
Up Next: You may have heard people talk about "compound interest" as though it is some magical financial trick. The idea is actually pretty simple: your money can earn money, and those earnings can then earn money of their own. In the next article, we'll look at Compound Interest and why time can be one of the most valuable parts of a long-term savings strategy.
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