What’s the Difference Between a Traditional IRA and a Roth IRA?
An individual retirement account (IRA) is used to set funds aside and invest savings for retirement later down the road. The account functions as a holding tool for a variety of assets, from stocks and bonds to certificates of deposits and money markets. There are two primary types of IRAs to choose from: traditional and Roth.
While each type of IRA has its pros and cons, both are an effective tool for saving for the future. One of the most enticing features of an IRA is its tax-advantaged nature — investments held in an IRA don’t have any tax implications as long as they remain in the account. This means your savings can grow and compound without increasing your income tax for the current year.
The main differences between a traditional IRA and a Roth IRA lie with how they’re treated by IRS, primarily how contributions and distributions are handled. Understanding the differences can help make your choice easier when choosing between the two retirement accounts.
What’s a traditional IRA?
A traditional IRA is a retirement savings and investment account. The biggest advantage of choosing a traditional IRA is your ability to deduct contributions from the current year’s taxable income. Thereby, giving you a form of a tax break. There are certain requirements you must meet to deduct your full IRA contribution amount. Determining factors include your tax filing status, whether you have access to an employer retirement plan, and your household income.
All traditional IRA contributions are made on a pre-tax basis, meaning they aren’t immediately subject to income tax. Instead, your funds are treated as a source of income — and, therefore, taxed — only when they’re distributed, or taken out of the account.
The downside of a traditional IRA is that your distributions may be subject to an early distribution penalty if the funds are withdrawn before the age of 59½. Additionally, you must begin gradually reducing your traditional IRA by making distributions the year you turn age 70½, even if you don’t need or want the funds at that time.
Although it has some distribution limitations, you can benefit from a traditional IRA if you’re currently in a relatively high tax bracket. The idea here is that you’ll pay fewer taxes now because your contributions are deductible. You can then take advantage of a lower tax bracket once you enter retirement, putting more money in your pocket and maximizing your savings over the long-run.
What’s a Roth IRA?
A Roth IRA is a popular alternative retirement savings and investment tool. While it has many similar characteristics as a traditional IRA, a Roth IRA offers more flexibility in terms of when you can make distributions. With a Roth IRA, you won’t incur any early distribution penalties if you choose to make a withdrawal of your past principal contributions. There’s also no mandatory distribution age, which means you’re able to decide when distributions are made based on your financial standing.
Unlike a traditional IRA, contributions to a Roth IRA are made with after-tax dollars. Your contributions aren’t deductible, which means you’ll pay taxes on your retirement money now. However, this opens the door for future tax-free withdrawals since you’ve already been taxed on that same income. Qualified distributions are 100% tax-free if:
The distribution is taken out five years after the Roth IRA is opened.
The distribution occurs due to one of the following: you’re 59 ½ or older, you’re disabled, a beneficiary receives the distribution because of your death, or the distribution is used to purchase your first home.
While you won’t get an immediate tax break like you will with a traditional IRA, you may benefit later down the road since qualified distributions are tax-free and penalty-free. If you’re currently in a lower tax bracket — for example, 10% or 12% marginal tax brackets — you likely won’t find yourself in an even lower tax bracket during retirement, so it may be more beneficial to choose a Roth IRA for its flexibility.
If you’re close to retirement age and don’t want to be required to begin making withdrawals or if you simply want easier access to your funds, then a Roth IRA may be a better choice.
Key differences to consider when planning for retirement
While there are many similarities, there are several key differences to focus on when choosing the right type of IRA for you.
Age limitation. A traditional IRA does not allow for contributions after the age of 70½ years, whereas a Roth IRA has no age limit.
Deductibility. Contributions made to a traditional IRA may be tax-deductible given certain parameters like income amount, but a Roth IRA is never deductible.
Treatment of Earnings. For a Roth IRA, qualified distributions are tax-free because you’ve already paid related taxes when the contribution was made. With a traditional IRA, earnings are added to your taxable income for the year they’re taken out.
Distribution Requirements. Traditional IRA owners must begin distributing minimum amounts when they reach age 70½. Roth IRA owners don’t have required distribution amounts at any age.
Many people choose to move forward with a traditional IRA due to its eligibility for tax deductions. However, that shouldn’t be your only determining factor. Consider whether the additional future benefits of a Roth IRA, such as tax — and penalty-free distributions, outweigh the benefits of a deduction on your current taxable income.
Factor in how long you have until retirement, as well as where you are currently and where you will in the future financially to help round out your decision for choosing which type of IRA is best for you.
If you’re still unsure about which option might make sense for you, schedule a free consult with a financial coach at The Gym.