Money

The Difference Between a Roth IRA & Traditional IRA

Mar 25, 2022
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If you're familiar with traditional investment vehicles, you've likely heard of Roth IRAs. Roth IRAs are among the more commonly used investment vehicles for families who qualify. Families exceeding a certain income cannot use Roth IRAs, but can still utilize traditional IRAs. Both Roth and traditional individual retirement accounts (IRAs) function similarly in many ways.

How do you distinguish between Roth vs. traditional IRAs? The difference in Roth IRA tax benefits is one of the primary delineations between these two investment vehicles, in addition to other distinctions. Indeed, taxes are the primary nuance that separates these two types of retirement accounts. 

Roth IRA explained

In many respects, a Roth IRA functions as a traditional IRA. Two of the most significant differences are in eligibility requirements and taxes. Roth IRAs have an eligibility requirement that excludes those who exceed these income levels. For individuals, the 2022 individual limit is $144,000. The limit for married couples filing jointly is $214,000. 

As for taxes, there are significant Roth IRA differences compared to traditional IRAs. Contributions aren't tax-deductible with a Roth IRA, but neither earnings nor withdrawals after retirement are taxed. On the other hand, contributions are tax-deductible with a traditional IRA, but withdrawals are taxed as income. 

The placement of tax advantage either before or after retirement is how many people choose which account type would be better for them.

Are you wondering, "How does a Roth IRA grow?" It's crucial to understand how compounded interest rates affect investments. IRAs — both Roth and traditional — are vehicles for investing in financial products like stocks and ETFs. As such, they grow when the assets they're invested in grow.

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That's where compounded interest plays a role. If an investment rises by a few percent one week, stays level for a month, and then increases by a few percent again, the amount your account earns off the second rise will be more than the first. That first percentage gain became part of your investment value. 

The second rise calculates from that. 

In essence, compounded interest is earning interest on your initial investment plus any interest already gained. This also goes in the opposite direction when your investments experience negative fluctuations. 

Beyond investment growth and compound interest, IRAs grow when you contribute to them. In 2022, there are no differences in contribution limits in a traditional IRA vs. Roth IRA, other than base eligibility for the Roth IRA. 

So long as you don't exceed the income eligibility requirements, you can have a traditional and a Roth IRA.

Investments, financial planning, and life insurance

While traditional investment vehicles like IRAs and 401(k)s are among the most recommended investment vehicles, there are situations where you can use life insurance policies as an investment vehicle. Suppose you've maxed out annual contributions to your other retirement accounts. 

In that case, a permanent life insurance policy can offer another tax-advantaged investment opportunity. The first question to ask yourself is, do I need life insurance? Before answering this question, it's important to understand the risk factors of living without life insurance.    

Next, consider different policies and how much you're willing to pay in premiums. For the most coverage per dollar, you'll want to consider term life policies. However, term policies don't include an investment feature. If you're looking for life insurance as an investment, you'll want to consider permanent life insurance, like whole life policies. For instance, you may decide that investing your tax return in life insurance should be part of your retirement planning. Ethos offers whole life insurance to people ages 66 to 85, so although the policies do have a cash value, they won't accrue as much value as a policy held for several decades. 

FAQ

Which is better, a traditional or Roth IRA?

It can depend much on your current tax bracket vs. the tax bracket you'll be in during retirement. A Roth IRA offers delayed tax benefits that help if your retirement tax bracket is higher than your current one. At the same time, traditional IRAs provide you with tax benefits now, but not on later withdrawals. 

What's the downside of a Roth IRA?

Eligibility requirements and contribution limitations are perhaps the most significant downsides of a Roth IRA. Not everyone can utilize a Roth IRA. Of those who can, there's an annual limit on how much you can put into that account. The same contribution limit applies to traditional IRAs, though, as both types of retirement accounts share this downside.

Is a Roth IRA worth it?

If you can afford the contributions and the market performs well, a Roth IRA could be worth it. However, individuals have too many complexities and specific needs to say that they're worth it for everyone.

The information and content provided herein is for informational purposes only, and it is not to be considered legal, tax, investment, or financial advice, recommendation, or endorsement. You should consult with an attorney or other professional to determine what may be best for your individual needs.

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