Investing News

Roth IRA vs. Traditional IRA: Key Differences

Roth IRA vs. Traditional IRA: An Overview

Individual retirement accounts (IRAs) are tax-advantaged vehicles designed for long-term savings and investment to build a nest egg for one’s post-career life. While some IRAs are available through your employer, the two most common ones are designed for investors to use on their own. The first is the traditional IRA, established in 1974, while the other is its younger cousin, the Roth IRA, introduced in 1997 and named for its sponsor, Sen. William Roth.

While these accounts are similar, they differ in some key ways—primarily dealing with tax deductions (do you want to owe the IRS now or later?), accessibility of funds, and eligibility standards. Understanding all the distinctions is crucial in deciding which IRA is the better choice for you.

Key Takeaways

  • The key difference between Roth and traditional IRAs lies in the timing of their tax advantages.
  • With traditional IRAs, you deduct contributions now and pay taxes on withdrawals later while Roth IRAs allow you to pay taxes on contributions now and get tax-free withdrawals later.
  • Traditional IRAs function like personalized pensions: In return for considerable tax breaks, they restrict and dictate access to funds.
  • Roth IRAs function more like regular investment accounts, only with tax benefits: They have fewer restrictions, but fewer breaks as well.
  • Whether you think your annual income and tax bracket will be lower or higher in retirement is a key factor in determining which IRA to choose.

Traditional IRAs

Traditional IRA contributions are tax-deductible on both state and federal tax returns for the year you make the contribution. As a result, withdrawals, which are officially known as distributions, are taxed at your income tax rate when you make them, presumably in retirement.

Contributions to traditional IRAs generally lower your taxable income in the contribution year. That lowers your adjusted gross income (AGI), possibly helping you qualify for other tax incentives you wouldn’t otherwise get, such as the child tax credit or the student loan interest deduction.

If you withdraw money from a traditional IRA before age 59½, you’ll pay taxes and a 10% early withdrawal penalty. You can avoid the penalty (but not the taxes) in some specialized circumstances like when you use the money to pay for qualified first-time home-buyer expenses (up to $10,000) or qualified higher education expenses. 

Permanent disabilities and certain levels of unreimbursed medical expenses may also be exempt from the penalty but you’ll still pay taxes on the distribution.

Roth IRAs

You don’t get a tax deduction when you make a contribution to a Roth IRA. This means it doesn’t lower your AGI that year. But your withdrawals from your Roth IRA during retirement are tax-free. That’s because you paid the tax bill upfront, so you don’t owe anything on the back end.

Roth IRAs have income-eligibility restrictions. In 2021, singles must have a MAGI of less than $140,000, with contributions being phased out starting with a MAGI of $125,000. Married couples must have modified AGIs of less than $208,000 to contribute to a Roth, and contributions are phased out starting at $198,000.

These limits increase for the 2022 tax year. The MAGI for single filers maxes out at $144,000
and begins to phase out at $129,000 while the MAGI range for married couples filing jointly is $204,000 to $214,000.

Roth IRAs carry no required minimum distributions (RMDs), which means you’re not required to withdraw any money at any age or during your lifetime at all. This feature makes them ideal wealth-transfer vehicles. Beneficiaries of Roth IRAs don’t owe income tax on withdrawals, either, though they are required to take distributions or else roll the account into an IRA of their own. Unlike a traditional IRA, you can withdraw sums equivalent to your Roth IRA contributions penalty- and tax-free at any time, for any reason, even before age 59½.

You can own and fund both a Roth and a traditional IRA assuming you’re eligible for each. But your total deposits in all accounts must not exceed the overall IRA contribution limit for that tax year.

Key Differences

Both traditional and Roth IRAs provide generous tax breaks. But it’s a matter of timing when you can claim them. Anyone with earned income can contribute to a traditional IRA. Whether the contribution is fully tax-deductible depends on your income and whether you (or your spouse, if you’re married) are covered by an employer-sponsored retirement plan, such as a 401(k).

Another difference between traditional and Roth IRAs lies in withdrawals. With traditional IRAs, you have to start taking RMDs, which are mandatory, taxable withdrawals of a percentage of your funds, at the age of 72 even if you don’t need the money. The IRS offers worksheets to calculate your annual RMD, which is based on your age and the size of your account.

Pre-Retirement Withdrawals

If you withdraw money from a traditional IRA before age 59½, you’ll pay taxes and a 10% early withdrawal penalty. You can avoid the penalty (but not the taxes) in some specialized circumstances: If you use the money to pay for qualified first-time home-buyer expenses (up to $10,000) or qualified higher education expenses. 

Permanent disabilities and certain levels of unreimbursed medical expenses, may also be exempt from the penalty, but you’ll still pay taxes on the distribution. In contrast, you can withdraw sums equivalent to your Roth IRA contributions penalty- and tax-free at any time, for any reason, even before age 59½.

If You Want to Withdraw Your Earnings

Different rules apply if you withdraw earnings (sums above the amount you contributed) from your Roth IRA. You would normally get dinged on those. If you want to withdraw earnings, you can avoid taxes and the 10% early withdrawal penalty if you’ve had the Roth IRA for at least five years and at least one of the below circumstances applies to you:

  • You are at least 59 ½ years old
  • Have a permanent disability
  • You die and the money is withdrawn by your beneficiary or estate
  • Use the money (up to a $10,000-lifetime maximum) for a first-time home purchase.

If you’ve had the account for less than five years, you can still avoid the 10% early withdrawal penalty if:

  • You’re at least 59 ½ years old.
  • The withdrawal is due to a disability or certain financial hardships.
  • Your estate or beneficiary made the withdrawal after your death.
  • You use the money (up to a $10,000-lifetime maximum) for a first-time home purchase, qualified education expenses, or certain medical costs.

Special Considerations for Roth and Traditional IRAs

A key consideration when deciding between a traditional and Roth IRA is how you think your future income (and, by extension, your income tax bracket) will compare to your current situation. In effect, you have to determine if the tax rate you pay on your Roth IRA contributions today will be higher or lower than the rate you’ll pay on distributions from your traditional IRA later. 

Although conventional wisdom suggests that gross income declines in retirement, taxable income sometimes does not. Think about it. You’ll be collecting (and possibly owing taxes on) Social Security benefits, and you may have income from investments. You might opt to do some consulting or freelance work, on which you’ll have to pay self-employment tax.

And once the kids are grown and you stop adding to the retirement nest egg, you lose some valuable tax deductions and tax credits. All this could leave you with higher taxable income, even after you stop working full-time.

In general, if you think you’ll be in a higher tax bracket when you retire, a Roth IRA may be the better choice. You’ll pay taxes now, at a lower rate, and withdraw funds tax-free in retirement when you’re in a higher tax bracket. If you expect to be in a lower tax bracket during retirement, a traditional IRA might make the most financial sense. You’ll reap tax benefits today while you’re in the higher bracket and pay taxes later on at a lower rate.

The Bottom Line

One way the two types of IRAs don’t differ: in terms of administration. Most brokerages act as custodians for both Roths and traditional IRAs with the same minimums, fees, and terms for each.

Articles You May Like

Is Nvidia (NVDA) Stock a Strong Buy for 2021?
Vistra (VST) and MasterCraft Boat (MCFT): 7/1/24 Bull & Bear
What is Stock Paper Trading and How Should You Learn To Trade Stocks
Stock Fundamental Analysis: Two Methods – Top-Down and Down-Up Approach
How Long Should You Spend on Analyzing a Stock Chart