What is the difference between a traditional IRA and a Roth IRA?

The distinction between a traditional IRA and a Roth IRA primarily revolves around their tax treatment, particularly regarding contributions and withdrawals. A traditional IRA allows individuals to make pre-tax contributions, which can be tax-deductible depending on the individual's income and whether they are covered by a retirement plan at work. This means that the money you put in reduces your taxable income in the year you contribute. However, when you eventually withdraw money in retirement, those distributions are taxed as ordinary income.

In contrast, Roth IRAs are funded with after-tax dollars, meaning that contributions are made from income that has already been taxed. The key benefit of a Roth IRA is that it allows for tax-free growth; once the account has been established for at least five years and you reach age 59½, you can withdraw both your contributions and earnings without paying taxes on them. This can lead to significant tax advantages in retirement, especially for those who expect to be in a higher tax bracket later in life.

This understanding aids in making informed decisions about retirement planning and helps individuals choose the IRA type that aligns best with their financial goals and situation.