What Are Roth IRAs and How Do They Work?

by Stacy Francis, CFP®, CDFA

This question popped up during a recent seminar, and as we dove into the topic, it turned out almost every attendee was at least a teeny bit confused about them. In case you are, too, I am going to provide some clarity below, highlighting the main difference between Traditional and Roth IRAs.

The government sets limits for how much individuals may contribute to traditional IRAs. At present, the maximum is $5,000 per year and individual. When you set this amount (or less) aside in an IRA account, you can deduct it from your taxes if your adjusted gross income is below $3,000 (single) or $8,000 (married). When the time comes for you to retire, you pay taxes on withdrawals from your IRA account (meaning, both the money you’ve saved and the returns you have made on your savings).

Contributions to Roth IRAs, on the other hand, are made on an after-tax basis. Therefore, you do not have to pay taxes when you withdraw the money. Since (hopefully) by the time you retire, you will have much more money in your account, theoretically, Roth IRAs are more advantageous.

There is, however, one major exception to this rule. If you expect to be in a significantly lower tax bracket when you retire, a Traditional IRA may make more sense. Say, for instance, that you are paying 36% tax right now, and will be in the 7% bracket in your senior years. Then it could be more advantageous to go the traditional way and pay the taxes in the future.

Both Traditional IRAs and Roth IRAs are complex and complicated, and many factors should weigh in when you decide which one to go for. Hopefully, this will help.

Be sure to check out our other articles on IRAs.