Opening an IRA is a great way to save for retirement. It allows you to make tax-advantaged contributions which may produce larger gains than investing in an account without similar tax advantages (where are the best Roth IRA rates?).
Most people are eligible to open Traditional and Roth IRAs, and depending on your financial situation, one of the two may be better than the other.
Comparing Traditional and Roth IRAs
Both a Traditional IRA and Roth IRA have certain tax advantages that make them good options for your retirement investments. The main difference is that a Traditional IRA is a tax-deferred retirement plan, and a Roth IRA is a tax-exempt retirement plan.
To put this another way, the difference between the two retirement plans is how and when you pay taxes on them.
How Traditional IRAs Work
Traditional IRA contributions are made with pre-tax money which will grow without taxes until you make withdrawals in retirement age, or under certain circumstances. The tax benefit will be recorded when you file your taxes next year, usually by reducing your taxable income by the amount of the contribution if you are eligible to contribute to a tax-deductible Traditional IRA based on your income.
To find out if you are eligible for tax-deductible contributions, check out the IRA contribution limits. Withdrawals from Traditional IRAs are taxed at the time of distribution. Traditional IRAs are also subjected to required minimum distributions starting at age 70½, regardless of whether or not you feel the need to make withdrawals.
How Roth IRAs Work
Roth IRA contributions are made with money that has already been taxed, and contributions are not tax-deductible when you make them. However, since the contributions were made with money that has already been taxed, qualified distributions can be made tax free. There are no required minimum distributions for Roth IRAs, which gives you more flexibility in retirement.
Please see the links above for Roth IRA income and contribution limits for more information about Roth IRA eligibility. Early withdrawal rules still apply; however, other tax rules permit withdrawals for events such as buying your first house, paying for college, and others. Please visit the IRS website or contact a tax professional for more details.
Beware of early withdrawal penalties. Making withdrawals before you reach retirement age may subject you to early withdrawal penalties. These penalties can cost you 10% of what you withdraw, and you have to pay taxes on the amount you withdraw immediately. So you can end up losing a large portion of your retirement fund by making early withdrawals.
Traditional and Roth IRA Features
There are several similarities between the traditional and Roth IRA. But they do offer different features and advantages, sometimes making one a better option than the other, depending on individual circumstances.
Traditional IRA Features
- Eligibility: Anyone under age 70½ can contribute to a Traditional IRA. However, you must meet certain income requirements to be able to deduct your contributions from your taxes. You can still contribute to a Traditional IRA if you exceed income requirements. However, it would be a nondeductible IRA.
- Contributions: Contributions can only be made from taxable, earned income. This is generally considered to be salary, wages, tips, bonuses, commissions, and self-employment income. Excluded income includes rents, royalties, investment income, and other non-taxable income.
- A note about earned income requirements: military members who are deployed to a tax-exempt combat zone for an entire year typically do not have any earned income for tax purposes. These members are still eligible to contribute to either a traditional or Roth IRA through provisions in the HERO Act).
- Taxes: Traditional IRA contributions are made from income that has not yet been taxed. This reduces the participant’s taxable income when he or she files their tax return. This provides an immediate tax advantage since the contributions are made on a pre-tax basis. Taxes are deferred and paid when you make withdrawals.
- Distributions: You can begin taking penalty-free withdrawals at age 59½. Withdrawals made before that age may require the participant to pay both taxes on the withdrawals, and early withdrawal penalties of up to 10%. It’s a good idea to speak with a tax professional or the IRS for further guidance. There are also Required Minimum Distributions (RMDs), starting at age of 70½. The IRS requires members to begin taking withdrawals at that age, so they can ensure they get a piece of the taxes that haven’t yet been paid on the investments. It’s a good idea to meet with a tax professional before you begin your RMDs to ensure you are taking a sufficient amount of withdrawals. Otherwise, you might subject yourself to additional penalties.
Roth IRA Features
- Eligibility: Tax-payers must meet Roth IRA income eligibility requirements to be eligible to contribute to a Roth IRA. The Roth IRA income limits change each year and are based on your tax-filing status.
- Contributions: Annual IRA contribution limits are the same for both Roth and Traditional IRAs. Like the Traditional IRA, Roth IRA contributions must be made from earned income.
- Taxes: The main difference in the Roth and Traditional IRAs is how and when the funds are taxed. Roth IRA contributions are made from money that you have already paid taxes on (post-tax income). The investments will then grow without you having to pay further taxes on them. You will also not have to pay taxes on the distributions when you make withdrawals. This gives participants much more flexibility regarding how and when they take funds from their Roth IRA.
- Distributions: Unlike the Traditional IRA, there are no Required Minimum Distributions to worry about. Members can leave their money in their Roth IRA until they need it, without having to worry about taking minimum withdrawals. Members can access contributions to their Roth IRA at any time. However, they cannot access the earnings from their contributions until the account has been open for at least five years, and the member has reached age 59½. Taking withdrawals earlier than that may subject the individual to early withdrawal penalties.
Which is Better Traditional or Roth IRA?
There is no one-size-fits-all approach to this question. The answer will entirely depend upon your unique circumstances. Both types of IRAs can offer you the opportunity for tax diversification and more flexibility in retirement.
Factors to consider: There are many factors to consider when comparing Roth and Traditional IRAs, including your current tax bracket and your expected tax bracket in retirement. You also need to consider current income, expected future income, Roth or Traditional IRA income eligibility, contribution limits, and Required Minimum Distribution requirements.
Tax-free Traditional IRA contributions phase out at lower income levels than Roth IRAs. So you may consider a Roth if you cannot receive the tax deductions from a Traditional IRA. There are also minimum withdrawal requirements for Traditional IRAs, while Roth IRAs do not have a required minimum distribution.
Which is better? Many financial experts recommend to start investing with a Roth IRA, if you are eligible, because they offer tax-free withdrawals and other benefits such as higher income levels for eligibility and no required minimum distributions. Overall, they provide more flexibility than Traditional IRAs. That said, there are times when a Traditional IRA is the right choice.
We have these two articles which further compare the pros and cons of Roth and Traditional IRAs:
- 6 Reasons to Choose a Roth IRA over a Traditional IRA
- 5 Reasons to Choose a Traditional IRA over a Roth IRA
Take some time to consider your situation before deciding which IRA to open. The long-term benefits are worth getting it right the first time! Here is more information about what to look for when opening an IRA.