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Roth IRA vs. Traditional IRA | What’s The Difference? (Full Guide)

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Unless you are 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 what these types of plans are and how they work, then you are in the right place. We will explain everything you need to know about both plans as well as the key differences between the two. The plan you choose can have large tax consequences, so making the right decision when it comes to a traditional vs Roth IRA could save you a load of money.

Roth IRA vs. Traditional IRA: The Short Version

So, what is a traditional IRA or a Roth IRA? Both the Roth and traditional individual retirement accounts are great ways to save for your retirement, and they share many of the same benefits. Both accounts allow for your investments to grow tax-free, and both are typically funded from your own 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 just developed in 1974 and the Roth account came along in 1997. So, which one is right for you?

While the main function of an IRA is to help you save for retirement, there are some things that can affect your decision when it comes to choosing between Roth vs 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 normal income tax on the withdrawals you make. 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 72, which might cause you to have serious 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 withdraw your earnings tax-free as well. Both accounts have the same IRA contribution limits, so tax status and fund accessibility are the two main factors that should affect your decision when choosing an account.

Key Differences Between A Roth IRA And A Traditional IRA

Roth and traditional are the two main types of IRAs, and there are some key differences between the two that you should be aware of. 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) less than $140,000 and married couples with MAGI less than $208,000. However, tax benefit phase-outs start at levels below those income limits. Traditional IRAs are open to anyone, although tax deductibility is dependent on income and participation in an employer sponsored plan.

The next major difference between Roth and traditional IRAs is the way contributions and withdrawals are treated by the IRS. With a traditional IRA, the IRS allows you to take a tax deduction on your IRA contributions now, but your withdrawals 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 investments grow tax-free, and you are not required to pay any taxes on the withdrawals you take.

Traditional IRA contributions are subject to required minimum distributions upon reaching age 72; 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 large tax savings in the long run. Lastly, there is a difference in when you can access your retirement savings. With a traditional account, you can only withdraw your money upon reaching age 59 1/2. Otherwise, you pay taxes and penalties. However, with a Roth account, you can withdraw your contributions at any time without paying taxes or penalties. Your investment earnings must remain in the account for 5 years and until age 59 1/2 to be withdrawn tax and penalty-free.

Traditional vs Roth IRA – Key Differences
Traditional IRA Roth IRA
Contribution Limits $6,000 in 2021. Age 50 and older – $7,000 $6,000 in 2021. Age 50 and older – $7,000
Effects of Early Withdrawal Distribution taxed as income plus additional 10% penalty for early withdrawal before age 59 1/2. No income taxes or penalties to withdraw contributions early. Earnings cannot be withdrawn penalty free until age 59 1/2.
Pros Contributions are tax deductible in current year. Withdrawals are tax-free.
Can withdraw contributions at any time without taxes or penalty.
Cons Withdrawals are taxed at current income tax rates.
Penalties incurred for early withdrawals.
Income limits restrict eligibility to contribute.
No tax benefits for contributions in the current year.

Distribution Rules

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Once you reach retirement age, you need to know what the rules are for distributions. What if you need to take a distribution before reaching retirement age? With a traditional account, you must wait until age 59 1/2 to take a withdrawal or distribution. If you make an early withdrawal, you will pay income taxes plus an extra 10% penalty. While your contributions to this account save you money on taxes when you make the contribution, you will be required to pay income taxes on the distributions when you receive them. The income tax rate is based on your total income during the year in which you receive the distributions. You might also be able to withdraw up to $10,000 for expenses associated with a first-time home purchase as well as make hardship withdrawals.

With a Roth account, you can take distributions tax-free because the contributions you make to the account are paid with after-tax dollars. This is a great option for those who are in a higher tax bracket during their retirement years. This way, you can save lots of money on your tax bill.

Income Limits

Depending on your current income, your choices in an IRA vs Roth IRA might be limited. As long as you have earned income, you can contribute to a traditional IRA. There are no income limits on contributions to a traditional account. However, there are some limits on tax deductibility of the contributions. If you make more than the limits, you will be unable to deduct your annual contribution amount on your tax return. With a Roth account, you might be unable to make contributions if your income is too high. For individuals making more than $140,000 or married couples earning more than $208,000, you will be unable to make Roth contributions.

Contribution Limits

Believe it or not, there are limits to how much you can contribute to these plans in any calendar year. For 2021, the contribution limits for the year are $6,000 for both the Roth and traditional IRAs. If you are age 50 or older, the IRS realizes that you might need to put a little more money into these savings accounts to have enough money for retirement. For that reason, they allow extra contributions from those age 50 and older. If you fall into that group, you can contribute up to $7,000 per year to these accounts. Again, the limits are the same for both Roth and traditional IRAs.

Pre-Retirement Withdrawals

Here is another area where the rules between the two types of accounts are quite different. Savers should choose carefully between the two by taking into consideration whether they might need to touch those funds before retirement. Your personal finances will play a big role in this decision, and your financial planner or tax advisor can also help you make this decision. Here is what you need to know when it comes to pre-retirement withdrawals.

With a traditional IRA, it is difficult to access your money before retirement unless you are willing to pay taxes and early withdrawal penalties. That will cost you an extra 10% on top of the normal income taxes. The only early distribution exception is that you are allowed to withdraw up to $10,000 for expenses related to the purchase of your first home, and you can make hardship withdrawals in some cases.

With a Roth IRA, you can make penalty and tax-free withdrawals from your contributions at any time for any reason. You cannot withdraw your earnings until they have been in the account for at least 5 years and you reach age 59 1/2. If you withdraw from your earnings early, then you will pay the penalty on those funds. If you have any questions about the tax implications from these types of transactions, you should always consult a tax professional for advice.

4 Reasons Why Most Retirees Go With The Roth IRA

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Many retirees choose the Roth IRA over the traditional one. There are a few reasons for this, and here are some of the most common.

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 come 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 also 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.

More After-Tax Savings At Retirement

Many individuals find themselves on a fixed income during their retirement years, so keeping expenses lower is a great way to save money each tax year. By investing in a Roth IRA, 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 plan for a regular, ordinary income with more certainty. Since you may also be receiving payments from a pension or 401(k) plan during retirement that are taxable, the Roth IRA can help keep your total taxable income lower.

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. Not only can you withdraw your money tax-free at retirement, but you can also withdraw 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.

Early Withdrawal Rules

This goes hand in hand with the fewer restrictions mentioned above. A Roth account allows you to withdraw funds before retirement without paying taxes or penalties. As long as you do not withdraw from the earnings on your account, then you will get your money free and clear. Early withdrawals from your contributions will not incur any penalties or taxes, while you still must wait 5 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 traditional IRA does not have to be extremely complicated. Most taxpayers can easily choose between the two 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 to participate in a Roth plan. You should plan according to your personal financial situation, and you can always consult your brokerage firm or financial planner for help.

Frequently Asked Questions

Is it smart to have a Traditional IRA and a Roth IRA?

Yes, if you can afford to make contributions to both types of accounts, then that will help you in the long run. This allows for tax diversification and helps keep your taxable income lower both today and during retirement.

How does a Roth IRA benefit me in my higher tax bracket?

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.

When should I switch from Roth to Traditional?

Even if your total income falls above the limits for Roth contributions, then you will be forced to switch to traditional contributions. If your income is near the limit, then you might go ahead and consider performing the IRA conversion at that time. You can perform the conversion at any time, but you must report it on that year’s tax returns.

What is the downside of a Roth IRA?

The downside of the Roth IRA is that you do not receive any 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 make contributions to a Roth account. You will be forced to use a traditional IRA in that case.