Traditional and Roth IRAs

Upbeat music plays throughout.

Narrator: If you're saving for retirement, IRAs, also known as Individual Retirement Accounts, can offer significant tax advantages.

This video focuses on how to choose between two common types of IRAs: traditional and Roth. Each provides different tax benefits.

In a taxable investment account, you have to pay taxes annually on most investment income and gains on investments you sell, which can slow the growth of the account.

A benefit of both traditional and Roth IRAs is that your investment income and any gains if you actively trade or sell a security aren't taxed while they're in your account, which can help your investments compound.

Where traditional and Roth IRAs differ is when you get tax breaks.

You essentially have a choice of receiving a tax deduction now or tax-free withdrawals later. Let me explain.

With a traditional IRA, your contributions may be tax deductible. This means you may get a tax break in the years you contribute to the account.

But you still have to pay taxes sometime. With a traditional IRA, you pay taxes on money you withdraw. Essentially, choosing a traditional IRA means you'll pay taxes when you take withdrawals, but you may get a tax deduction now.

Ok, so let's talk about Roth accounts. With a Roth IRA, contributions are not tax deductible, meaning you don't get a tax break when you make contributions.

Once you contribute money to a Roth IRA, you won't have to pay taxes on your withdrawals as long as you've held that account for five years. So, choosing a Roth account means getting a tax break later.

So, which one is better? It depends.

Based on your personal circumstances, it's possible that one type of account might be better for you. The biggest factor is whether you think your tax rate during retirement will be higher or lower than your tax rate during the years you're contributing.

If you think your taxes are higher now than they'll be when you retire, a traditional IRA might be better. For example, by retirement, your mortgage might be paid off or maybe your kids will be out of the house, so you'll need less income.

With this lowered income during retirement, your tax rate may be lower. A traditional IRA would allow you to pay taxes when you take withdrawals and take advantage of the lower tax rate rather than paying your higher tax rate now.

On the other hand, a Roth IRA may be the best choice if you think your tax rate could be higher when you take withdrawals, often during retirement. For example, if you're a young investor who's just starting a career, you may expect to pay higher taxes later in your career and into retirement.

By choosing to pay taxes now at a lower tax rate, you may benefit by paying less than you would in retirement. Plus, you'll have the comfort of knowing you'll be unburdened by taxes when you withdraw from your Roth IRA during retirement.

However, there are a few things to remember. First, it can be very difficult to predict future tax rates. As a result, many experts recommend contributing to both a traditional and a Roth account as a way to spread out your tax savings.

Second, if you think you'll need access to money in your IRA before you retire, a Roth IRA may be a better choice. With a Roth IRA, you're able to withdraw your contributions at any time—though if you withdraw earnings on those contributions, they may be subject to income taxes and penalties.

But with a traditional IRA, many withdrawals prior to age 59 and a half are subject to a penalty and taxes. However, some withdrawals for things like higher education, medical expenses, or the purchase of a first home might not be penalized in certain circumstances.

Third, there are limits on IRA eligibility and tax benefits.

Animation: A 401(k) folder and a traditional IRA folder with tax-deductible crossed out appear on screen.

Narrator: For example, if you already have a retirement plan through your employer, traditional IRA contributions may not be tax deductible.

And some investors may make too much money to contribute to a Roth IRA. Be sure to check the IRS's income limits and consult a tax professional.

While it can be hard to predict your future tax rate, both traditional and Roth retirement accounts can help you maximize your retirement savings with tax benefits. The most important thing is to contribute early and often.

On-screen text: [Schwab logo] Own your tomorrow^®