Traditional and Roth IRAs: Benefits and Drawbacks

Traditional individual retirement accounts (IRAs) and Roth IRAs are both widely used investment vehicles for workers trying to accumulate long-term assets. However, the way these two accounts work is different, with each having its own advantages and disadvantages.

The IRA was created decades ago as defined-benefit pension plans were declining. Becoming more popular as workers started to take control of their retirement savings, the IRA offers individuals an opportunity to save for retirement in a tax-advantaged account.

In a traditional or Roth IRA account, you can invest in all sorts of traditional financial assets, such as stocks, bonds, exchange-traded funds (ETFs), and mutual funds. You can invest in a wider range of investments through a self-directed IRA (one in which you, the investor, not a custodian, make all the investment decisions)—your options may include commodities, certain precious metals, real estate, or even peer-to-peer loans. However, no matter which type of IRA, you may not invest in life insurance or in collectibles such as artwork, rugs, antiques, gems, and stamps.

IRA accounts are relatively easy to set up, but the rules that govern these accounts vary. While they offer tax benefits, there are limits to how much you can contribute.

Benefits of Traditional and Roth IRAs

IRAs offer several distinct advantages, including the following:

Tax-free Growth

Both Roth and traditional IRAs offer immediate tax-free growth of assets. This means that once the money is in the account, no taxes are levied on the dividends or capital gains that the investments earn until distribution.

The Roth IRA takes this one step further. Having paid taxes on contributions, all qualified earnings in the future can be withdrawn tax-free. Be mindful that although no taxes are due for non-distributions from a traditional IRA leading up to retirement, distributions are taxable for a traditional IRA.

Tax Deductions

While Roth IRA contributions are made with after-tax dollars, traditional IRA contributions are made with pre-tax dollars. This means traditional IRA contributions can be deducted from your income—in most cases—although there are certain limitations.

The deductibility is determined by income levels as well as whether you are covered by a workplace retirement account, such as a 401(k). The limits are determined based on income and the individual's tax-filing status. As a person's income increases, the amount of the tax deduction that can be taken can be reduced partially or fully. Below are the deduction limits for 2022 and 2023.

If you file separately and did not live with your spouse at any time during the year, your IRA deduction is determined under the single filing status.

Both traditional and Roth IRAs have the same contribution deadline. You are allowed to contribute to your IRA during the entire calendar year and up to the tax filing deadline of the following year.

Drawbacks of Traditional and Roth IRAs

While the pros of IRAs generally outweigh the cons, there are a few drawbacks to be aware of.

Contribution Limits

IRAs have strict contribution limitations. To contribute to an IRA, you or your spouse need earned income. For 2022, the maximum contribution amount per person is $6,000, and those aged 50 and older can make a $1,000 catch-up contribution. For 2023, the maximum contribution amount per person is $6,500 (along with a $1,000 catch-up contribution). However, if your modified adjusted gross income (MAGI) exceeds a certain level, you may not be able to contribute to a Roth IRA.

If you were married filing separately and you did not live with your spouse at any time during the year, your tax status is single.

Penalties

Since the IRA is intended for retirement, there are often certain penalties if you take out your money before retirement age.

With the traditional IRA, you face a 10% penalty on top of the taxes owed for any withdrawals before age 59½. With the Roth IRA, you can withdraw a sum equal to your contributions penalty and tax-free at any time.

However, you can only withdraw earnings without getting dinged with the 10% penalty if you’ve held the account for five years and have reached age 59½.

There are a few exceptions to these early withdrawal rules. Early distributions of earnings for these reasons are considered exceptions: taxable as income but not subject to the 10% penalty. The most popular include:

• Withdrawals up to $10,000 to help pay for the first home for yourself, your spouse, children, or grandchildren
• Withdrawals to pay for college expenses
• Withdrawing up to $5,000 in the year after the birth or adoption of your child
• Distribution for unreimbursed medical expenses that exceed 10% of your adjusted gross income for the year or health insurance premiums while you are unemployed

Required Withdrawals

There are mandatory withdrawals for your traditional IRA called required minimum distributions (RMDs), starting when you reach age 72 (or 73, starting in 2023). The withdrawal amount is calculated based on your life expectancy, and it will be added to that year's taxable income. There is a 25% penalty, plus taxes owed if you fail to take the RMD. If corrected promptly, that penalty can be reduced to 10%.

A popular benefit of the Roth IRA is that there is no required withdrawal date. You can leave your money in the Roth IRA to let it grow and compound tax-free as long as you live. What's more, any money you do choose to withdraw is tax-free.

The Bottom Line

IRAs can be a powerful savings tool, especially if you've maxed out your 401(k) contributions or don't have access to a workplace retirement plan. Those in a relatively low tax bracket now may want to consider a Roth IRA, where you contribute post-tax dollars but have the opportunity to withdraw funds tax-free in retirement, when you may be in a higher bracket.