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Roth IRA Basics and How They’re Different From a Traditional IRA

January 31, 2016 by Justin 9 Comments

roth ira basicsOne of the biggest stumbling blocks to getting started with an IRA (individual retirement arrangement) is knowing which type of one to sign up for.  Should I sign up for a Roth or Traditional?  We know that both are useful, but which one will give you most amount of benefit over the long term?  To really understand this, it helps to know your Roth IRA basics and how they are different from those of a Traditional IRA.  Although both are excellent tools to be used in conjunction with your IRA vs 401k strategy, it is also likely that one of them will be better suited to your individual needs.

To help you understand the differences, here is a brief and easy to follow overview of the Roth IRA basics and how they compare to a Traditional IRA.  You will notice that in a lot of ways they are the same.  But then there are also some subtle differences that can make one more appealing over the other.

 

How They are Similar:

One of the fundamentals of Traditional and Roth IRA basics is just like your employer retirement account (the 401k or 403b), their purpose is to give individuals an incentive to save money for retirement by giving them a tax break.  To some people that may not sound like a big deal, but the more savvy among you will realize that this is huge advantage over the traditional way of saving money!

The great thing about an IRA is that you set it up yourself outside your employer.  This can be done with any popular discount broker like Vanguard, Fidelity, etc or bank.  Your account can consist of any combination of common investments such as mutual funds, stocks, bonds, CD’s, etc.

If you meet the requirements, you can setup either a Roth, Traditional, or both types of IRA’s so long as the combination of funds do not exceed the maximum contribution limits.

• 2013 IRA contribution limits: $5,500 per year or $6,500 if you are 50 or older.

Each person in the household is allowed to contribute so long as they meet minimum income requirements.

 

Traditional IRA Basics:

• Started in 1986

• You get a tax deduction in the year you contribute

• Once you invest, your money grows tax free.

• You pay taxes on the money you eventually take out for retirement (meaning you pay taxes later)

• You don’t have access to your money until age 59 and a half without paying a penalty.  To take the money out sooner, you have to consult the special exceptions under IRS Code section 72(t).

• After age 70-1/2, you do have to start taking out required minimum distributions

• Once you setup a Traditional IRA, you have the option to convert it to a Roth IRA later.

 

Roth IRA Basics:

• Started in 1997

• You do not get a tax deduction in the year you contribute (meaning you pay taxes now)

• Once you invest, your money grows tax free.

• You do not pay taxes on the money you eventually take out for retirement.

• You don’t have access to your investment gains and dividends until age 59 and a half without paying a penalty.  You can however take out the principal (the amount you initially put in) five years after you invested.  To take the rest of you money out sooner, you have to consult the special exceptions under IRS Code section 72(t).

• After age 70-1/2, you do not have to start taking out required minimum distributions

• Once you setup a Roth IRA, you do not have the option to convert it to a Traditional IRA later.

 

Photo Credit: Microsoft Clip Art

Related posts:

  1. What Is a Non Deductible IRA and How Do I Contribute To One?
  2. The Comprehensive Financial Planning Guide for Beginners
  3. How to Set Up a Self-Directed IRA the Right Way
  4. How to Invest a Little Bit of Your IRA or 401k to Binary Options Trading

Filed Under: Basic Rules Tagged With: IRA contribution limits, Roth IRA Basics, Traditional IRA Basics

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