Hi. Can you tell me what is a Roth IRAa and a traditional IRA and the differences between the two? Can you explain it clearly so i can understand it better? Thank you.

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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Roth IRAs and Traditional IRAs are two kinds of individual retirement accounts.  The major difference between the two has to do with when your money is taxed.

Individual retirement accounts are accounts that you can set up with a financial institution to fund your retirement.  You set up an IRA, for example, if you do not have a pension plan or a 401(k) with your employer that you think will provide enough money for your retirement. The IRA allows you to supplement your pension and 401(k), if any, and the Social Security benefits that you receive once you retire. 

So why set up an IRA rather than just putting your money in the bank or buying stocks and bonds?  The answer has to do with taxes.  IRAs are in some way protected from taxation.  The specific kind of protection is the main difference between a Roth and a traditional IRA.

When you get paid, your income is taxed.  If you put your money in a bank account and it earns interest, the interest is taxed.  If you buy stocks and you get dividends from those stocks, those are taxed.  Most people would prefer to avoid this if they can.  This is where IRAs come in.

With a traditional IRA, the money that you put into the account is not taxed.  You can only put in a certain amount each year, but you get to take the money you put in out of your taxable income for the year.  You pay taxes when you get the money out, but not when you put it in.  If you think that you will be in a lower tax bracket after you retire, you might want to use a traditional IRA because then you will pay less in the way of taxes on your money.

With a Roth IRA, the money that you put in is taxed.  You do not get to deduct your contributions from your taxable income.  However, the money is not taxed when you take it out.  This can mean that it would be better to go with a Roth IRA if you think that taxes will be higher after you retire.

There are other considerations that would determine which IRA is best for any given person’s situation.  Follow some of the links below to find out more.

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