Welcome to Two Minute Money, Yahoo Finance’s new personal finance series offering quick explanations for some of the most important questions involving your money.
Do you know the difference between an IRA and a Roth IRA? More than half of all Americans don’t—and we admit the two can be confusing. But we’re here to break it down. Both types of IRAs largely function the same way. You can only contribute $5,500 a year, and you can only withdraw money before you turn 59 and a half for things like buying a home or paying medical bills.
When the money gets taxed
The big difference between a Roth and traditional IRA comes down to when the money you put in the account is taxed. In a traditional IRA, taxes are taken out when you withdraw your savings in retirement, and your annual contributions can lower your tax bill. You deposit your money into the account in monthly increments and watch it grow. Then, when you turn 59 and a half, you can withdraw your funds. The money is taxed after you take it out of the account.
With a Roth IRA, your money is taxed before you put it in your account instead of when you take it out. You still contribute in monthly increments, but you pay your taxes at your current tax rate. A Roth IRA is a great option if you expect to get raises over your career and retire in a higher tax bracket than you are in now.
Income limits and where your employer plan fits in
Note that a Roth IRA has an income limit. If you earn more than $133,000 in 2017, you are ineligible for a Roth, so you’ll need to switch to a traditional IRA. Traditional IRAs aren’t restricted by income, but if you have an employer-sponsored retirement account like a 401(k), your ability to deduct your IRA contributions will start to be restricted at $61,000. Of course, if your employer matches your 401k contributions, you should invest there first. After all, that’s free money from your work.
Which IRA is for you?
The Roth IRA is definitely the more popular option. It had almost one and a half billion dollars more in contributions than traditional IRAs in 2013. But there are upsides to both retirement accounts. If you’re planning on retiring early and living frugally for many years, or if think your income will decrease, then a traditional IRA may be better. If you’re young and you expect to make more money later in life, a Roth IRA is your best bet.