This story is part of the CNBC Make It One-Minute Money Hacks series, which offers simple, easy tips and tricks to help you understand your finances and take control of your money.
If you are young and investing for the first time, you may be faced with a confusing decision: a traditional IRA or Roth IRA? For most, Roth is the right choice, according to many financial experts.
Two types of accounts offer tax benefits, the main difference being whether you want to pay taxes now or later.
With a traditional IRA, your contributions reduce taxable income for the current year. Then the money is invested, and when you take it out after the age of 59, you owe income tax. Similar to job 401 (k), you deferred your tax bill.
With the Roth IRA, you invest money that has already been taxed. When you withdraw it in retirement, you will get tax-free, assuming you follow the conditions for withdrawal.
Basically, you paid taxes. If you are now in the low tax bracket and expect your income to grow throughout your career – and thus reach the higher tax bracket – it makes sense to contribute to Roth and lock in that low tax rate now.
In addition, income tax rates are currently extremely low, thanks to changes to the 2017 tax law, which makes Roths even more attractive. It is almost certain that tax rates will increase in the end.
Another benefit of the Roths: You can understand this as a contingency account. If necessary, you can withdraw your contributions at any time, without taxes and penalties (any investment gains you withdraw earlier will be taxed). On the other hand, eavesdropping on a 401 (k) or traditional IRA in an emergency means paying a 10% penalty for early withdrawal, plus the tax you owe (with exceptions).
That said, most financial planners advise not to retire from your Roth – or any other retirement account – prematurely, so you give more time to your contributions collect compound interest.
But keep in mind that Roth IRAs have certain income limits. Individuals must have a modified adjusted gross income (MAGI) below $ 140,000 for tax year 2021, and married couples must have a MAGI below $ 208,000 to contribute to Roth.
Finally, you must also meet the conditions for withdrawal because otherwise you will be penalized. You can usually withdraw both your contributions and interest earned after the age of 59 ½ if the first contribution to the account was made at least five years ago.
Exceptions to this include buying a home for the first time, the cost of a qualified college, some birth or adoption costs, and qualified medical expenses, which can often be withdrawn earlier.
Individuals who meet income limits can contribute up to $ 6,000 in 2021 if they are under 50, and $ 7,000 if they are 50 or older.
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