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What Is a Traditional IRA, Roth IRA and Backdoor Roth IRA?

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What Is a Traditional IRA, Roth IRA and Backdoor Roth IRA?

Question-And-Answer

Timmy-

An IRA or Individual Retirement Account, it is not in itself an investment account but rather a personal savings plan account that was created under U.S. law as an incentive to help people save for retirement.

The main difference from a traditional 401k and an IRA is that a 401k may be set up by an employer to for the benefit of his employees whereas and IRA may be opened directly by a business owner or people who are self-employee for themselves.

There are many different types of retirement plans and the most popular are:

  • Traditional IRA
  • Roth IRA

The money you contribute into either of this account, can be used to invest by purchasing several different types financial instruments such as stocks, mutual funds, futures, etc which hopefully will appreciate in value over time until retirement.

Both of this type of savings accounts, the Roth and the Traditional IRA, offer many great benefits, but how would you know which one to choose that can work best for you?

A couple sitting with a financial advisor learning about investment options

What is a Traditional IRA?

The traditional IRA’s main feature is that all of the money that you contributed throughout the year into the account may lower your taxable income, however, the withdrawals at retirement will be subject to income tax at the current rate. Some of the benefits of this account include tax credits

And some restrictions for contributing into this account include income limitations and if your spouse already contributes through a plan at work you may only be able to contribute then you can only take the full deduction up to the amount of your contribution limit.

What is a Roth IRA?

A Roth IRA is the second most popular IRA savings account. Since the contributions into this account are after tax dollars there is no tax deduction, however, when the time comes for retirement, you will not be subject to income tax on withdrawals from the Roth Account. All growth and earnings on this account as well as the withdrawals are tax-free. Another benefit of this account is that you may be able to withdraw your contributions from the account minus the earnings so you will not incur in any penalties.

The main limitation of the Roth IRA account are certain income restrictions which will prevent you from making a direct contribution into the account, there is a work around called doing a Back-door Roth conversion.

What is a Back-door Roth IRA?

Once you have surpassed the income limitations to contribute directly into the Roth IRA, you can still make contributions to the Roth IRA through a process called “back door conversion” which consists in making a contribution to a Traditional IRA to then convert it to a Roth IRA. The amount of money that you contribute to a Roth IRA is normally limited however a backdoor Roth Ira has no limits on the amount of the conversion.

How to decide which one is best for you?

The main thing to consider when choosing between the Traditional IRA versus the Roth IRA is whether the benefits of the Roth (such as the tax-free qualified distributions) outweigh the benefits of a deduction from the Traditional IRA, that will ultimately lower your taxable income.

In conclusion, It is usually advised that you would always want to contribute to the Roth IRA if you are expecting your tax rate to be higher in the future. Since you have already paid taxes on the money that you contribute into this account at your current tax rate, even if you are at much higher tax bracket int the future, you will not be subject to income tax on your distributions from the Roth IRA account.

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