Roth IRA vs. Traditional IRA: An Overview
An individual retirement account (IRA) is a way to save for retirement and save on taxes as well. Designed primarily for self-employed people who don't have a company retirement plan like a 401(k) plan. there are two types of IRA: the traditional IRA and the Roth IRA.
Though their goals are similar, traditional and Roth IRAs differ in some key ways:
The traditional IRA allows you to contribute a portion of pre-tax dollars. That reduces your taxable income for the year while setting aside the money for retirement. The taxes will be due as you withdraw the money. The Roth IRA allows you to contribute post-tax dollars. There are no immediate tax savings but once you retire the amount you paid in and the money it earns are tax-free.
- 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 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 homebuyer 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.
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 phasing 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 phase 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.
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.
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 homebuyer 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 59½ 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 59½ 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.
|Comparing Traditional and Roth IRAs|
|Rules||Roth IRA||Traditional IRA|
|2021 Contribution Limits||$6,000; $7,000, if age 50 or older||$6,000; $7,000, if age 50 or older|
|2022 Contribution Limits||$6,000; $7,000, if age 50 or older||$6,000; $7,000, if age 50 or older|
|2021 Income Limits||Single tax filers with MAGIs of less than $140,000 (phaseout begins at $125,000) and married couples filing jointly with MAGIs of less than $208,000 (phaseout begins at $198,000) are eligible.||Anyone with earned income can contribute, but tax deductibility is based on income limits and participation in an employer plan.|
|2022 Income Limits||Single tax filers with MAGIs of less than $144,000 (phaseout begins at $129,000) and married couples filing jointly with MAGIs of less than $214,000 (phaseout begins at $204,000) are eligible.||Anyone with earned income can contribute, but tax deductibility is based on income limits and participation in an employer plan.|
|Age Limits||No age limitations on contributions.||No age limits on contributions.|
|Tax Credit||Available for “saver’s tax credit.”||Available for “saver’s tax credit.”|
|Tax Treatment||No tax deductions for contributions; tax-free earnings and withdrawals in retirement.||Tax deduction in contribution year; ordinary income taxes owed on withdrawals.|
|Withdrawal Rules||Contributions can be withdrawn at any time, tax-free and penalty-free. Five years after your first contribution and age 59½, earnings withdrawals are tax-free, too.||Withdrawals are penalty-free beginning at age 59½.|
|Required Minimum Distribution||None for the account owner. Account beneficiaries are subject to the RMD rules.||Distributions must begin at age 72 for the account owner. Beneficiaries are also subject to the RMD rules.|
|Extra Benefits||After five years, up to $10,000 of earnings can be withdrawn penalty-free to cover first-time homebuyer expenses. Qualified education and hardship withdrawals may be available without penalty before the age limit and five-year waiting period.||Up to $10,000 penalty-free withdrawals to cover first-time homebuyer expenses. Qualified education and hardship withdrawals are also available.|
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 when 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.
Frequently Asked Questions
Can I Contribute to Both a Traditional and a Roth IRA?
You can contribute to a traditional IRA as well as a Roth IRA as long as you meet certain requirements. You can contribute only up to the maximum $6,000 annual limit—$7,000 if you are 50 or older—for 2021 and 2022 across all IRAs.
Is Maxing Out an IRA a Good Idea?
Generally speaking, yes. Even if you think the market is overpriced, it's generally worth making the maximum contributions to your IRAs. The tax savings you will make are likely to be far larger than the slightly inflated cost of stocks, shares, and funds.
Should I Choose a Roth or a Traditional IRA?
It depends. The key issue is whether your income tax rate will be greater or lesser than the time when you begin withdrawing funds from the account. That is probably impossible to know for sure, so you are forced to make an educated guess. Factors to consider are your current tax rate and whether you think your tax rate will be far higher in the future.
The Bottom Line
The United States Senate Committee on Finance. "Expanding IRA's," Page 1.
Internal Revenue Service. "Traditional and Roth IRAs."
Internal Revenue Service. "IRA Deduction Limits."
Internal Revenue Service. "Topic No. 557 Additional Tax on Early Distributions From Traditional and Roth IRAs."
Internal Revenue Service. "Publication 590-B Distributions from Individual Retirement Arrangements (IRAs)," Page 24.
Internal Revenue Services. "Income Ranges for Determining IRA Eligibility Change for 2021."
Internal Revenue Service. "Amount of Roth IRA Contributions That You Can Make for 2022."
Internal Revenue Service. "Retirement Topics — Required Minimum Distributions (RMDs)."
Internal Revenue Service. "Required Minimum Distribution Worksheets."
Internal Revenue Service. "Publication 590-B Distributions from Individual Retirement Arrangements (IRAs)," Page 28.
Internal Revenue Service. "Publication 590-B (2020), Distributions from Individual Retirement Arrangements (IRAs)."
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