Can someone please explain like I’m five the difference between an IRA and a Roth IRA and why it would be needed?
In: Economics
The two types of IRAs have two different tax treatments and results.
The Roth IRA, the money going in has already been taxed and so when you take money out, after you are 59 1/2, that money isn’t taxed.
With a traditional IRA, the money going it, was not taxed. So when that money is taken out after age 59 1/2 you will owe taxes on it.
In both IRAs, your dividends, capital gains, interest is not taxed while the funds are inside the IRA. So both IRAs are good places to hold stocks and when you buy or sell them, you aren’t taxed on the gains. But you also can’t deduct any losses.
The other main difference between the two types is that in a traditional IRA, after you reach age 72/73, depends on the date, you are REQUIRED to take $$ out of your traditional IRA. There is a
formula for doing so but the guvment makes you take money out and taxes you on it. In your Roth IRA, the assets can stay inside the IRA as long as you live.
Hope this was helpful.
IRA – You invest untaxed income. When you retire and start withdrawing the money it’s all taxed as income.
Roth – You invest taxed income. When you retire and start withdrawing it’s non-taxable income. So all your profits are 0% tax income.
Roth is best for the vast majority of people and offers the best tax benefit unless you have a very high income.
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When you fully retire, you need an income source to live off of. Most Americans get **Social Security**, but it’s usually not enough to live comfortably. You could save your money in a savings account, but the interest is low. You could invest in stocks in a normal brokerage account, but you still have to pay taxes on it.
Since the government doesn’t want a bunch of bankrupt/homeless senior citizens (and upping the Social Security tax would have huge backlash), they allow **tax-advantaged brokerage accounts** for retirement purposes.
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Savings & taxable brokerage: taxed twice
Tax-advantaged brokerage: taxed once
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These come in many forms, the 2 most popular being a **401(k)** and an Individual **Retirement Account (IRA)**.
A 401(k) is something your job would have to offer, which not all do. An IRA is something you can setup on your own (there are income limits and whatnot, but your average American will qualify).
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**Traditional** retirement accounts are ones where you only pay income taxes when you take the money out, thus you don’t pay the taxes now when you deposit money.
**Roth** retirement accounts are ones where you only pay income taxes now when you deposit, thus you don’t pay the taxes when you take the money out.
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For an IRA, if you have a 401(k) or similar at your job then you likely can’t do Traditional (well you can, but no tax benefit), this is why Roth IRA is so popular because more people qualify for it.
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