Unless you have been planning for your retirement, you might not know what a Roth or traditional IRA is. It is never too early to start a retirement plan, and you should start saving as soon as possible to maximize the amount of money you have when you reach retirement age.
If you are unsure about these plans and how they work, you are in the right place. We will explain everything you need to know about both plans and the critical differences between them.
Your plan can have significant tax consequences, so making the right decision regarding a Traditional vs Roth IRA could save you a lot of money.
Roth IRA vs Traditional IRA: The Short Version
So, what is a Traditional IRA or a Roth IRA? The Roth and Traditional individual retirement accounts are great ways to save for your retirement and share many of the same benefits.
- Both accounts allow for your investments to grow tax-free and are typically funded from your personal funds.
While some IRAs may be sponsored by an employer, most traditional and Roth IRAs are funded by individuals.
- Both types of accounts are somewhat new, as the traditional IRA was developed in 1974, and the Roth account was introduced in 1997.
So, which one is right for you?
While an IRA’s primary function is to help you save for retirement, some factors can affect your decision to choose between Roth and Traditional IRAs.
The first consideration is the tax benefit. You should consider whether you plan to be in a higher tax bracket at retirement or the same or lower tax bracket.
- Since a Roth account allows you to pay taxes today and withdraw funds tax-free, you should generally choose a Roth account if you plan to be in a higher tax bracket during retirement.
- However, with a traditional IRA, you contribute tax-deferred funds. This means that your contributions are tax-deductible today, but you pay ordinary income tax on withdrawals. So, choose traditional if you plan to be in the same or a lower tax bracket at retirement.
You should also consider the accessibility of your funds.
- Traditional accounts will require you to pay income taxes and a 10% early withdrawal penalty if you withdraw the funds before age 59 1/2. There are also required minimum distributions (RMDs) beginning at age 73, which might cause you to have considerable tax implications.
- With a Roth account, you can withdraw your contributions at any time for any reason, penalty-free. After five years and reaching age 59 1/2, you can also withdraw your earnings tax-free.
Both accounts have the same IRA contribution limits, so tax status and fund accessibility are the main factors affecting your decision when choosing an account.
KEY TAKEAWAYS
- There are certain advantages to a Roth IRA and a Traditional IRA, so participating in both accounts can provide a solid foundation for retirement planning.
- The most significant advantage of a Roth IRA is that the gains on your investment grow tax-free. If you contribute $100k and then it grows to $1m, you wouldn’t pay taxes on the $900k gain.
- The main advantage of the Traditional IRA is you get an immediate tax deduction in the year you make contributions. This reduces your taxable income and saves on current taxes.
Key Differences Between A Roth IRA And A Traditional IRA
Roth and Traditional are the two main types of IRAs, and you should be aware of some key differences between them.
The first difference is eligibility. There are income limits that restrict eligibility to make Roth IRA contributions.
- These accounts are open to single tax filers with modified adjusted gross income (MAGI) of less than $161,000 and married couples with a MAGI of less than $240,000. However, contribution limits begin phasing out at $146,000 and $230,000, respectively.
- Traditional IRAs are open to anyone, although tax deductibility depends on income and participation in an employer-sponsored plan. Contributions are no longer tax deductible for single tax filers with modified adjusted gross income (MAGI) of less than $161,000 and married couples with a MAGI of less than $240,000. However, full deductibility begins phasing out at $146,000 and $230,000, respectively.
Note: You can always contribute the maximum allowed to your Traditional IRA. However, you may not always get the tax deduction.
The next significant difference between Roth and traditional IRAs is the IRS treatment of contributions and withdrawals.
- With a traditional IRA, the IRS allows you to take a tax deduction on your IRA contributions now. Still, your withdrawals of contributions and gains are treated as taxable income during retirement.
- A Roth account, on the other hand, requires after-tax contributions, so you do not get any tax breaks today. However, your contribution and gains grow tax-free, and you are not required to pay any taxes on your withdrawals.
Traditional IRA contributions are subject to required minimum distributions upon age 73; however, Roth IRA accounts have no minimum distribution requirements for the account owner. Beneficiaries will be subject to RMDs, but this rule can still lead to considerable tax savings in the long run.
Lastly, there is a difference in when you can access your retirement savings.
- You can only withdraw your money at 59 1/2 with a traditional account. Otherwise, you pay taxes and penalties.
- With a Roth account, you can withdraw your contributions anytime without paying taxes or penalties. Your investment gains must remain in the account until age 59 1/2 and for at least five years before being withdrawn tax and penalty-free.
| Traditional IRA | Roth IRA | |
|---|---|---|
|
Phase Out Rules |
Contributions are no longer tax deductible for single tax filers with modified adjusted gross income (MAGI) of less than $161,000 and married couples with a MAGI of less than $240,000.
Plusr, full deductibility begins phasing out at $146,000 and $230,000, respectively. |
You can only make contributions to these accounts as single tax filer if your modified adjusted gross income (MAGI) is less than $161,000 and married couples with a MAGI of less than $240,000.
Plus, contribution limits begin phasing out at $146,000 and $230,000, respectively. |
|
Contributions Limits |
In 2024, you can contribute up to $7,000
If you are 50 or older, you can contribute an additional $1,000 |
In 2024, you can contribute up to $7,000
If you are 50 or older, you can contribute an additional $1,000 |
|
Effects of Early Withdrawal |
Distribution taxed as income plus an additional 10% penalty for early withdrawal before age 59 1/2 |
No income taxes on distributions
Earnings withdrawn prior to age 59 1/2 are subject to a 10% penalty Original contributions can always be withdrawn tax-free |
|
Pros |
Contributions are tax deductible in current year |
Contributions can be withdrawn at any time without taxes or penalties
Distributions of both contributions and gains are tax-free |
|
Cons |
Withdrawals are taxed at current income tax rates
Early withdrawals may be subject to penalties |
Income limits restrict eligibility to contribute
No tax benefits for contributions in the current year |
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Distribution Rules
Once you reach retirement age, you need to know the rules for distributions. But what if you need to take a distribution before reaching retirement age?
Traditional IRA Distribution and Withdraw Rules
- With a traditional account, you must wait until age 59 1/2 to take a withdrawal or distribution. If you withdraw early, you will pay income taxes plus an extra 10% penalty.
- While your contributions to this account save you money on taxes when you contribute, you must pay income taxes on the distributions when you receive them.
- The income tax rate is based on your total income during the year you receive the distributions.
Under certain circumstances, you may be able to withdraw funds early, similar to taking a 401(k) early withdrawal without penalty.
- The only early distribution exception is that you can withdraw up to $10,000 for expenses related to the purchase of your first home and make hardship withdrawals in some cases.
Roth IRA Distribution & Early Withdraw Rules
The guidelines for Roth distributions are less stringent since the money contributed to the account has already been taxed.
- With a Roth account, you can take distributions tax-free because the contributions you make to the account are paid with after-tax dollars.
- You cannot withdraw your earnings until they have been in the account for at least five years and reach 59 1/2. If you withdraw from your earnings early, you will pay the penalty on those funds.
If you have any questions about the tax implications of these types of transactions, you should always consult a tax professional.
Income Limits
Depending on your current income, your Traditional IRA versus Roth IRA choices might be limited.
- You can contribute to a traditional IRA if you have earned income. There are no income limits on contributions to a Traditional account. However, there are some limits on the tax deductibility of the contributions.
You cannot deduct your annual contribution amount on your tax return if you make more than the limits.
- With a Roth account, you might be unable to make contributions if your income is too high. You cannot make Roth contributions for individuals making more than $161,000 or married couples earning more than $240,000.
Contribution Limits
Believe it or not, there are limits to how much you can contribute to these plans in any calendar year.
- For 2024, the contribution limits for the year are $7,000 for both the Roth and traditional IRAs.
If you are 50 or older, the IRS realizes that you might need to put more money into these savings accounts to have enough money for retirement. Therefore, they allow extra contributions from those aged 50 and older.
- If you fall into that group, you can contribute up to $8,000 annually to these accounts. Again, the limits are the same for both Roth and traditional IRAs.
TIP
A Roth IRA is one of the best retirement accounts (especially if you start young) since all the gains grow tax-free. So, the more you can contribute to increase your profits, the greater the tax savings.
4 Reasons Why Most Retirees Go With The Roth IRA
Many retirees choose a Roth IRA over a Traditional one. There are several reasons for this; here are some of the most common.
1) Tax Diversification Through Joint Roth/401(k) Funding
Many people want the best of both worlds. It would be great to enjoy tax advantages today and still make withdrawals at retirement without paying taxes. This is where an IRA and 401k plan comes into play.
- If you have a 401(k) plan, you might be able to take advantage of a similar situation. You can contribute funds to your 401(k) on a pre-tax basis and enjoy tax benefits today while also contributing funds to a Roth IRA to enjoy tax-free withdrawals upon retirement.
This helps get you some tax credits today while keeping your taxable income lower in retirement. By diversifying your tax obligations, you help prevent a huge tax bill and instead spread your tax payments out. This option might even be available to those of you on solo 401(k) plans.
2) More After-Tax Savings At Retirement
Many individuals are on a fixed income during retirement, so lowering expenses is a great way to save money each tax year.
- Investing in a Roth IRA means you will not be required to pay taxes on those funds when you withdraw them. This helps prevent a surprise tax bill and lets you more accurately plan for a regular, ordinary income.
Since you may also receive taxable payments from a pension or 401(k) plan during retirement, the Roth IRA can help lower your taxable income.
3) Fewer Restrictions
A Roth IRA comes with considerably fewer restrictions, so that is why many people go that route.
- It is much easier to access your money should you need it before retirement. You can withdraw your money tax-free at retirement without taxes or penalties from your contributions at any time for any reason.
There is no hardship requirement or home purchase requirement. If you need the money for any reason, then you can withdraw from your initial contribution amounts.
4) Early Withdrawal Rules
This is in conjunction with the fewer restrictions mentioned above. A Roth account allows you to withdraw funds before retirement without paying taxes or penalties.
- You will receive your money free and clear if you do not withdraw from your account’s earnings.
Early withdrawals from your contributions will not incur penalties or taxes, but you must wait five years and reach age 59 1/2 to withdraw from the earnings on your investments.
Traditional IRAs have early withdrawal penalties similar to a 401(k). It is difficult to withdraw early without penalties from those accounts.
The Bottom Line
Choosing between a Roth and a Traditional IRA does not have to be extremely complicated. Most taxpayers can easily make the decision once they are armed with the information presented in this article.
A Roth IRA offers many advantages over a traditional IRA, although not everyone can qualify for a Roth plan.
Your financial situation will dictate the best option for you, plus you can consult your brokerage firm or financial planner for help.
Frequently Asked Questions
Yes, if you can afford to contribute to both types of accounts, that will help you in the long run. This allows for tax diversification and helps lower your taxable income today and during retirement.
Remember that the combined contribution cannot exceed the contribution limits if you contribute to both accounts.
If you expect to be in a higher tax bracket during retirement, then a Roth IRA can help you immensely.
Not only will it help prevent you from paying taxes on your withdrawals in a higher bracket, but it can also keep your taxable income lower and prevent you from moving into an even higher bracket and paying more taxes on your other income.
There is no set rule for selecting a Traditional IRA vs a Roth IRA. It’s a good idea to have each type of account.
You can make contributions to your Roth IRA as long as your income is below the IRS-designated income limits.
Once your income exceeds the limit, you can switch your contributions to a Traditional account.
You can also split your contributions between the two accounts if you don’t exceed the contribution limits.
The downside of the Roth IRA is that you do not receive immediate tax benefits. Your contributions are still taxable during the year in which you contribute.
In addition, if your income is too high, you are not qualified to contribute to a Roth account. You will be forced to use a traditional IRA in that case.
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