This story is part of CNBC Make It’s One-Minute Money Hacks series, which provides easy, straightforward tips and tricks to help you understand your finances and take control of your money.
If you’re young and investing for the first time, you may be facing a confusing decision: traditional IRA or Roth IRA? For most, a Roth is the right choice, according to many financial experts.
The two types of accounts both offer tax advantages, the main difference being whether you want to pay taxes now or later.
With a traditional IRA, your contributions lower your taxable income for the current year. The money is then invested, and when you take it out after age 59½, you owe income taxes. Similar to a workplace 401(k), you’ve deferred your tax bill.
With a Roth IRA, you invest money that’s already been taxed. When you withdraw it in retirement, you get the gains tax-free, assuming you follow the withdrawal requirements.
Basically, you’ve pre-paid your taxes. If you are in a low tax bracket now and expect your income to grow over your career — and thus reach a higher tax bracket — it makes sense to contribute to a Roth and lock in that low tax rate now.
Plus, income tax rates in general are extremely low right, now thanks to the 2017 tax law changes, making Roths even more attractive. It is almost certain that tax rates will eventually increase.
Read the Roth IRA fine print
Another perk of Roths: You can think of it as a back-up emergency account. If you need to, you can withdraw your contributions at any time, tax- and penalty-free (any investment gains you withdraw early will be taxed). On the other hand, tapping into a 401(k) or a traditional IRA in an emergency means paying a 10% early withdrawal penalty, plus whatever taxes you owe (with some exclusions).
That said, most financial planners advise against withdrawing from your Roth — or any other retirement account — early so you give your contributions more time to accrue compound interest.
But keep in mind that Roth IRAs have certain income limits. Individuals must have a modified adjusted gross income (MAGI) under $140,000 for the tax year 2021, and married couples must have a MAGI under $208,000 to contribute to a Roth.
Finally, you also must meet withdrawal requirements or you’ll be hit with penalties. Typically, you can make withdrawals of both your contributions and interest earned after age 59½ if the first contribution to account was made at least five years prior.
Exceptions to this include first-time home purchases, qualified college expenses, some birth or adoption expenses and qualified medical expenses, which can often be withdrawn earlier.
Individuals who meet the income limits can contribute up to $6,000 in 2021 if they are under age 50, and $7,000 if they are 50 or older.
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