Should you open a Traditional or Roth IRA?
/As you’re thinking through your retirement plan and researching different strategies, you will come across a lot of options. As freelancers, many of us will not have access to a 401(k), but there are plenty of other accounts you can utilize. One of those accounts is know as an IRA.
What is an IRA?
An IRA is an individual retirement account. In the United States, this individual retirement plan is provided by many financial institutions and provides tax advantages for retirement savings. The tax advantages are one of the reasons why you may opt for a retirement account versus using your savings account to save for retirement. The other big benefit is the interest you earn in a retirement account is much higher over time compared to traditional or high-yield savings accounts.
An individual retirement account is a type of individual retirement arrangement as described by the IRS Publication 590. These accounts are set up by taxpayers where you purchase an annuity contract or endowment contract from a life insurance company.
Individual retirement arrangements were first introduced in 1974 with the enactment of the Employee Retirement Income Security Act (ERISA). Taxpayers could contribute up to fifteen percent of their annual income or $1,500, whichever is less, each year and reduce their taxable income by the amount of their contributions. The contributions could be invested in a special United States bond paying six percent interest.
Initially, ERISA only allowed IRAs to be available to independent contractors or folks that were not covered by an employment-based retirement plan. This changed in 1981, when the Economic Recovery Tax Act (ERTA) allowed all working taxpayers under the age of 70 to contribute to an IRA, regardless of their coverage under a qualified plan. This act also raised the maximum annual contribution to $2,000 and allowed participants to contribute $250 on behalf of a nonworking spouse. Since then many changes have been made to IRAs, and each year the maximum amount that can be contributed usually increases.
What is the difference between a Traditional IRA and a Roth IRA?
Contributions to a Traditional IRA are often tax-deductible. Once you retire, the withdrawals from this account are subject to income tax.
Contributions to a Roth IRA are not tax deductible. Once you retire, the withdrawals from this account are tax-free.
Depending on your situation, one may be more appealing than the other. If you wish to minimize your current tax liability and have more access to cash this year, than choose the traditional. If you anticipate being in a much higher tax bracket as you enter retirement age, then choose the Roth.
Which one should you choose? Well, like most financial questions the answer is “it depends”. From my perspective, I say why not do both. Have your cake and eat it, too.
Or as I say, have your money and mimosas too.
