With all the different types of IRAs and specific rules of each, it’s no wonder there is so much confusion.  What do you expect from a government-designed program regulated by the IRS? The problem is that it’s human nature to avoid things that seem complicated, even if it’s in our best interest to participate. Although there is currently over $9 Trillion in IRAs there is a severe lack of knowledge and awareness of these tax-advantaged accounts.  So instead of going over every detail and term of each let’s cover the two most popular. 

Traditional IRA

  1. Funded with pre-tax dollars just like an employer plan. (401k, 403b, TSP, 457)
  2. Trades within the account do not create taxable events. Buy and sell as much as you want.
  3. *The account grows Tax-Deferred until distributions are taken.
  4. There is a 10% penalty for distributions taken before the age of 59 ½.
  5. Distributions are taxed as income. 
  6. Employer plans can usually be rolled over with no taxable events or penalties.

*The thought behind deferred taxes is that typically when taking distributions later in life one is no longer in their prime earning years.  Therefore, in a lower tax bracket and thus paying less in taxes on these funds. This, on top of the compounding gains that hopefully have accumulated over the years, makes Traditional IRAs extremely popular. 

Roth IRA

  1. Funded with post-tax dollars.
  2. Trades within the account do not create taxable events. Buy and sell as much as you want.
  3. *The account grows Tax-Free as long as no gains are taken as a distribution until the age of 59 ½ and the account has been established for 5 years
  4. There is a 10% penalty for distribution of gains before the age of 59 ½. 
  5. The original contribution can be taken as a distribution at any time.  The age and 5-year rule do not apply because you have already paid taxes on those funds.
  6. A Traditional or other tax-deferred IRA can be converted to a Roth IRA at any time.  This will create a one-time taxable event.

*A Roth IRA gives investors a ‘pay now, save later’ tax advantage. You forego any possible tax deductions upfront for tax-free gains later.  

Which is Best?

From my experience, a tax-free Roth IRA is where everyone wants to be but getting there may not be the right move for everyone.  For example, converting a large Traditional IRA may be too big of a tax liability for some. Many Traditional IRAs are funded from rollovers of employer plans and can be sizeable.  Bear in mind you can always do a partial conversion to a Roth IRA and have both types of accounts.  Other questions come up when making a new contribution; some have too high of an income to get a tax deduction for contributing to a Traditional IRA and also, too high of an income to contribute directly to a Roth IRA.  If that is the case, a Backdoor Roth IRA may be the best option.  

At the end of the day, everyone has their own unique situation and must determine which IRA is right for them.  However, there is no doubt that investing through IRAs is one of the smartest ways to invest and grow wealth. Just ask the millions of Americans who have over $9 Trillion of investments in them.  

And remember–It’s not about how much money you make, it’s about how much money you keep!

Disclaimer: I am not a licensed financial or tax advisor — consult with your financial/tax professional to determine what is best for you.