One very common investing vehicle is the the IRA (Individual Retirement Account), but which is better, the Roth IRA or the Traditional IRA? These are very commonly talked about but the nuances between the two are rarely dug into.
The type of IRA you utilize can make a big difference in your financial life, now and in the future.
This article will talk about some of the nuanced differences and what we feel is the best choice between the two.
- Traditional IRA: tax-deferred contributions, up to $6,000/year (or $7,000 if over 50), mandatory withdrawals at age 70 1/2, early withdrawal penalties apply.
- Roth IRA: after-tax contributions, no tax deductions, no mandatory withdrawals, and continued contributions allowed after age 70 1/2.
- Roth IRA contributions have income limits, while Traditional IRA has no income limit but age limitations on contributions.
- Both IRA types have the same annual contribution limits ($6,000 or $7,000 if over 50), and rollovers don’t count toward this limit.
- Traditional IRA offers tax deductions on contributions, while Roth IRA allows tax-free withdrawals during retirement.
- Roth IRA may be better if you expect higher taxes in the future, while Traditional IRA might be more suitable if you expect a lower tax income during retirement.
What is a Traditional IRA?
A traditional IRA is a retirement account that allows you to save money and to grow on what is known as a tax-deferred basis. Annually, people younger than 50 can contribute up to $6,000 to a traditional IRA. After they are 50, they can contribute up to $7,000 per year.
Tax deferred means that you will not pay taxes up front on the income, but rather on the tail end, when you chose to withdraw the money, during retirement or otherwise.
You can deduct your contributions to a traditional IRA on your taxes in the year you make them, as long as you’re eligible. If you withdraw money from the account before you turn 59 1/2, you will be charged a 10 percent penalty. The early withdrawal rule has a few exceptions.
You’re required to start taking money out of your traditional IRA when you turn 70 1/2.
What is a Roth IRA?
A Roth IRA is similar to a traditional IRA, but there are a few important differences. One difference between a traditional IRA and a Roth IRA is that Roth IRA contributions are made after taxes while traditional IRA contributions are made before taxes. This difference means a couple of things.
Although you can write off contributions to a traditional IRA on your taxes, contributions to a Roth IRA are not tax-deductible. With a Roth account, you are not subject to the early withdrawal penalties that apply to traditional IRAs. You will be charged a penalty if you take out the interest that you have earned.
You are not required to take a minimum distribution from a Roth IRA, and you are allowed to continue contributing to a Roth IRA after you turn 70 1/2.
What Is The Difference Between A Roth IRA & Traditional IRA?
You can save and invest for retirement in a traditional or Roth IRA in a way that will save you taxes.
IRAs deliver tax breaks in two primary ways:
An IRA is a retirement savings account that you can invest in without having to pay capital gains taxes. If you earn similar amounts of money in an ordinary taxable account with a robo-advisor or a brokerage house, you will have to pay high capital gains taxes.
A traditional IRA allows you to make tax-free contributions, but you will have to pay taxes on the money when you withdraw it. A Roth IRA will not reduce the amount of taxes you pay on your income now, but you will be able to withdraw money from the account without having to pay taxes on it.
Let’s look at this key difference more closely.
Traditional IRA = Tax-Free Contributions
Your contributions to a traditional IRA, up to the limit set by the IRS each year, will not be taxed. The IRS changes this limit every few years. Unless you are between 50 and 70-½, in which case you can contribute up to $7,000 tax-free, you can currently contribute $6,000 tax-free.
A pre-tax contribution from you will help lower the amount of taxes you owe for the current year. However, when you later withdraw the funds, you will have to face the income tax burden.
Roth IRA = Tax-Free Withdrawals
That is, you’ve paid taxes on the money you’re using to contribute. With a Roth IRA, the money you contribute has already been taxed. Depositing money will not lower this year’s taxable income.
This means that you will not have to pay income tax on the money you withdraw from your Roth IRA later in life.
The amount of money you are allowed to contribute to your Roth IRA each year is set by the IRS and is the same as the limit for traditional IRAs. Your investment will grow without being taxed.
Account Setup, Contribution Deadlines, and Age Limitations
Whether you are opening a traditional or Roth IRA, the process is easy. You need to decide if you want to open a traditional IRA or Roth IRA account.
Which financial institution you choose for your IRA will affect what type of IRA you can open. Afterwards, you will want to fund your account and then pick your investments. To be eligible to make contributions to a Roth IRA, you must first ensure that you meet the requirements.
If you earn more than the maximum income for making annual Roth contributions, you can still roll over savings from another account to create a backdoor Roth IRA. This means that you can take money out of your account without having to pay taxes on it either when you retire or when you reach age 70 1/2.
You can open a traditional IRA regardless of your age, and there is no income limit. You cannot open a traditional IRA after you reach age 70 1/2, and you cannot make contributions to a traditional IRA after you reach age 70 1/2.
If you are eligible, you can open and contribute to a Roth IRA. Roth IRAs have maximum income limits. If your income as a single person is above $122,000, you are not able to contribute the maximum amount to your Roth IRA. The maximum income limit for Roth IRA contributors is $137,000. For individuals that are married, the Roth IRA contribution limit starts to decrease at $193,000 in income, with a maximum income of $203,000.
There are annual contribution limits for traditional and Roth Individual Retirement Accounts (IRAs). If you are younger than 50, you can contribute a maximum of $6,000 per year to either a Roth IRA or a traditional IRA. People aged 50 and over can contribute an extra $1,000 a year, giving a total of $7,000 a year.
If you contribute to both a traditional and Roth IRA, your total contribution cannot exceed the maximum contribution limit. You can only contribute the maximum annual amount to one account. It’s important to know that rollovers don’t count toward the annual contribution limit.
Taxes and Deductions
There are different tax benefits for traditional and Roth IRA accounts. The money that you contribute to a traditional IRA is done so on a pre-tax basis. The following allows your savings to grow without being taxed, however you will be taxed when you start making withdrawals at the standard tax rate.
This means that the money you contribute to a Roth IRA has already been taxed, unlike a traditional IRA where contributions are made before taxes are paid. You will not have to pay taxes on the money you receive from your retirement account when you retire.
If you are eligible, any contributions you make to a traditional IRA can be deducted from your taxes in the year they were made. You cannot deduct contributions that you make to a Roth IRA on your tax return.
Withdrawals, Borrowing, Distributions, and Penalties
When comparing a traditional IRA to a Roth IRA, there are also differences in withdrawals, distributions, and penalties. If you withdraw money from a traditional IRA account before you reach the age of 59 1/2, you will have to pay a 10 percent penalty on the amount withdrawn, in addition to any taxes that may be owed on the withdrawal.
There are some traditional IRA early withdrawal exceptions, however. You may be able to take an early withdrawal from an IRA before you reach age 59 1/2 without paying a penalty in the following situations:
- You are disabled and can provide documentation of your disability and your inability to complete any substantial gainful activity;
- You have unreimbursed medical expenses that exceed 10 percent of your modified AGI;
- You are unemployed and have received unemployment compensation for at least 12 consecutive weeks, and you withdraw money from your IRA to pay for your health insurance premiums;
- You withdraw money to pay for qualified higher education expenses for yourself, your spouse, your child, or your grandchild;
- You withdraw up to a maximum of $10,000 for a first-time home purchase; or
- You are the beneficiary of an inherited IRA.
Roth IRAs are unique in that you are allowed to withdraw your contributions without being penalized if you are over the age of 59 1/2 and you have owned the account for more than five years. However, you will be taxed on your withdrawals. If you take money out of your Roth IRA before you’re supposed to, you will have to pay a 10% penalty unless you meet one of the exceptions.
Tax Break Now or Later?
The key difference between Roth and traditional IRAs is when you can claim the tax break. With a Roth IRA, you claim the tax break when you make contributions, while with a traditional IRA, you claim the tax break when you make withdrawals.
If you have a traditional IRA, you can save money before taxes are taken out, which means you would reduce your taxable income by up to $6,000 this year.
If the $6,000 reduction in earned income moves you into a lower tax bracket, your entire tax bill might be lowered even more.
Unlike a traditional IRA, a Roth IRA’s contributions are not immediately tax-deductible. However, when you withdraw the money later (presumably during retirement), you will not have to pay taxes on it.
Answering this question may require some help from a tax professional, but here are some common scenarios:
If you could reduce your taxable income by $6,000, you might be able to lower your income tax bracket. This could lead to big savings on your taxes from year to year. A traditional IRA can help you by reducing your tax burden immediately.
If you think you will have a lower tax income when you retire, you could save money by having a traditional IRA. If you take money out of your retirement account during retirement, you will be taxed at the rate for your income during retirement, not the higher rate you are paying now.
If you think you will be in a higher tax bracket when you’re retired, it makes more sense to have a Roth IRA. This is because you would pay taxes now, when you’re in a lower tax bracket, and avoid higher taxes later.
Should I Open A Roth Or Traditional IRA?
A very easy way to save money for retirement is to open a Roth IRA and contribute as much money as allowed each year.
The money you make will not be taxed, and you will be able to take the money out of the IRA easier than a traditional one.
When you retire, you can take money out of your Roth IRA without having to pay income tax on the funds.
Not all millennials will benefit from a Roth IRA. This text provides information about two types of Individual Retirement Accounts (IRA), with a focus on the benefits of a traditional IRA. It also mentions income restrictions that could make someone ineligible for a Roth IRA.
Both a Roth and a traditional IRA can help you save for retirement.
However, the answer for me is to use a Roth IRA first. Why? Because of the front loading (paying now) of taxes.
The old saying goes, “It’s better to pay tax on the seed rather than the harvest”. Especially in the current economic environment of today, with extreme money printing, inflation and deficit spending, taxes must go up at some point to pay for everything the government wants.
Hence, it’s better to pay taxes now rather than in the future where it’s likely (in my opinion) to pay more taxes in the future.
Can You Have Both A Traditional And Roth IRA?
You could open both a traditional and Roth IRA if you meet the age and income requirements for both types of accounts.
There is a limit to how much you can contribute each year without being taxed.
If you split your contribution between two or more accounts, you would be splitting your maximum contribution, which is currently $6,000.
Is it Smart to Have Both a Traditional IRA and a Roth IRA?
There are advantages to contributing to both a traditional and a Roth IRA.
We can’t predict our tax situation in the future. If you invest in both a Roth IRA and a traditional IRA, you will have more options to choose from later in life.
You’d also have more flexibility. What if, for example, you took on a part-time job in your 70s and started to earn more income? What if you started your own consulting business and had to pay self-employment income taxes?
In some cases, it may be beneficial to withdraw money from a Roth IRA rather than a traditional IRA account in order to receive a tax break.
Even if you converted your traditional IRA to a Roth IRA, you would still have to make the minimum withdrawals from your traditional IRA that are required by current law. At least with this option, you would have more control over how much tax you would pay.
Is A Roth IRA Worth It?
If you are already taking advantage of your employer’s 401(k) match, a Roth IRA will probably be most beneficial for you.
If you haven’t already started investing in a Roth IRA, I recommend doing so today, if you meet the income qualifications. A traditional IRA is a better option if you don’t have any of the special circumstances described above.
What are my other options?
Outside of what we normally discuss here at 40PlusFinance.com, such as investing in cash flowing assets utilizing a financial freedom plan, there are other options. While the two above IRAs are the most commonly used options, there are alternatives.
One such alternative is the Self-Directed IRA or SDIRA. The big difference is this and the other two options mentioned above is that you can hold alternative types of investments inside of it.
Things such as real estate, precious metals or commodities can be held in them.
Kurt has gone from the financial lows of the ’08 financial crisis to personal financial success. He is a professional real estate investor owning properties in multiple states.
One of his passions is financial education and the pursuit of financial freedom.
You can learn more about Kurt here.