Saving for retirement is crucial, and many people choose an individual retirement account (IRA). However, there are two primary options: traditional and Roth IRA. Which one should you choose?
This article will compare the Roth IRA and traditional IRA. You’ll learn the benefits of each, the disadvantages, and any distinguishing factors. Overall, this should help you understand the differences and help you determine which one is right for you. However, it’s always wise to talk to a financial advisor before making any big decisions.
What Will I Learn?
- Understanding Individual Retirement Accounts
- Distinguishing Features of a Roth IRA and a Traditional IRA
- Evaluating the Roth IRA and Traditional IRA: Pros and Cons
- Eligibility Criteria for a Roth IRA and a Traditional IRA
- Dual Contribution: Roth IRA and Traditional IRA
- Navigating Early Withdrawals and Minimum Distributions
- Choosing the Right IRA for Retirement Saving
- Frequently Asked Questions
Understanding Individual Retirement Accounts
The federal government created the individual retirement account to help individuals save for retirement. Overall, the money they contribute will grow tax-free. This is a huge advantage to most people.
If you do not pay taxes on the growth while it’s in your IRA, the money will compound faster than if it was immediately taxed. However, it’s important to select the right one, so it’s time to learn about Roth IRAs and traditional IRAs. Should wish to learn the basics of IRAs, our guide provides detailed insights on individual retirement accounts.
Defining a Roth IRA
Typically, Roth IRA contributions aren’t tax-deductible. Therefore, you will pay taxes on the money you contribute to the account before it goes in. However, you can then make tax-free and penalty-free withdrawals later.
Defining a Traditional IRA
Traditional IRAs offer the potential for people to make tax-deductible contributions for their retirement needs. You’ll only pay taxes when you withdraw money. Ultimately, you will get a deduction on your taxes for the years you put money in, paying them back when you take money out.
The Role of IRAs in Retirement Planning
Overall, an IRA is like a long-term retirement savings plan that offers tax advantages. People use them to plan for their later years. In a sense, you’re not allowed to touch that money until a certain age (or a specific time frame has passed), so you can’t use it until you’re older.
Typically, they work well for people who aren’t sure how to invest. However, they do come with risks, and it’s possible to have less money at the end than you put in throughout the years. Therefore, it’s crucial to work with a financial advisor and a reputable company.
Distinguishing Features of a Roth IRA and a Traditional IRA
Understanding the features of Roth and traditional IRAs might help you decide which one is right for you. Here are the things to consider:
Tax Considerations (Tax Benefits and More)
With a traditional IRA, you might be allowed to deduct your contributions from your income taxes. Likewise, the growth in the account isn’t taxable until you withdraw it. However, you will pay taxes on the money as you take it out.
Alternatively, Roth IRAs work differently. The contributions are made with after-tax dollars; you pay taxes on the money before it goes into the account. Then, the growth within is not taxable until it’s withdrawn. In some cases, it could be given to you tax-free if you meet certain conditions.
Pre-tax and Post-tax Contributions
Roth IRAs use after-tax dollars. Therefore, you’re paying taxes on the money you contribute to the account. Alternatively, traditional IRAs use pre-tax dollars for the contributions. You can then use that as a tax deduction and are taxed when you withdraw money.
Tax Deductions and Non-Deductions
In most cases, the contributions you make are deductible from your taxes if you have a traditional IRA. However, there are a few exceptions here. For example, if you or a spouse participate in a retirement plan sponsored by your employer and your Modified Adjusted Gross Income (MAGI) exceeds a specific dollar amount, you may not be able to take the deduction.
However, Roth IRAs don’t allow you to deduct contributions from your taxes.
Tax-Free and Tax-Deferred Earnings
You also need to be aware of tax deductibility for both types of accounts. Traditional IRAs offer a tax break today. You’re not taxed immediately and can deduct the amount you contribute on your tax return for that year. The money growth is considered tax-deferred because you don’t pay taxes until you withdraw the cash.
Alternatively, Roth IRAs do not offer immediate tax benefits. You use after-tax dollars when contributing. However, the compounded growth that builds up is then yours tax-free when you withdraw.
One of the main differences between the two types of IRAs is income eligibility. Let’s take a look at them now:
Income Limits/Restrictions for a Roth IRA
If you have an earned income, you could be eligible for a Roth IRA. However, there are income limits in place. Overall, the contribution amount is based primarily on your Modified Adjusted Gross Income. Single tax filers require a MAGI of less than $138,000 (2023 tax year), and that number is $146,000 or less in 2024.
Those married filing jointly require a MAGI of $218,000 to $228,000 in 2023 and $230,000 to $240,000 in 2024 if they wish to qualify for a Roth IRA.
Income Considerations for a Traditional IRA
There are no income limits for a traditional IRA. If you have earned income, you qualify.
It’s crucial to be aware of the contribution limits allowed for both types of IRAs. There are also age-related rules to consider. Let’s check them out now:
Annual Contribution Limits
Regardless of whether you have a traditional or Roth IRA, your annual contribution limit is $6,500 for 2023 and will be $7,000 in 2024.
Age-Related Contribution Rules
Those who are over 50 years old can contribute $7,500 in 2023 and $8,000 in 2024.
Regulations on Withdrawals
When deciding which retirement vehicle is right for you, it’s crucial to understand the withdrawal process. You want to know when to take out money, what age you can do so, and all the rest. Here are the withdrawal regulations for both types of accounts:
Early Withdrawal Penalties
With a traditional IRA, you could be subjected to a 10 percent penalty if you withdraw money before you are 59.5 years old. Likewise, the funds will likely be considered income, so you’d pay ordinary income taxes on the amount you take out.
Roth IRAs let you withdraw contributions at any time. There could be penalties and taxes if you dip into the earnings too soon, though.
Required Minimum Distributions
You must start taking your required minimum distributions (RMDs) when you turn 73 if you have a traditional IRA account. However, there are no distribution requirements in a Roth IRA.
Evaluating the Roth IRA and Traditional IRA: Pros and Cons
Now that you know the rules for traditional and Roth IRAs, it’s important to focus on the pros and cons. Let’s take a look at them now:
Benefits of a Roth IRA
In this section, we’ll discuss the advantages of choosing a Roth IRA which include:
You pay taxes on the contributions upfront, so you see tax-free growth and can often receive your earnings without paying additional taxes. Likewise, there is no early withdrawal penalty to take out what you’ve contributed (there are a few exceptions here).
No Required Minimum Distributions
There’s no requirement to withdraw money from your Roth IRA, regardless of your age. You can keep the money in the Roth IRA forever, handing it down to a charity or heir tax-free.
Drawbacks of a Roth IRA
Though a Roth IRA is a great choice for many people, there are a few drawbacks to consider:
There are income limitations, so you need to find out what your Modified Adjusted Gross Income is. It must be under $138,000 (2023) and $146,000 (2024) if you’re a single filer and want to put in the maximum contribution each year. However, if you make more than that, your contribution limit is reduced based on a sliding scale. After $153,000 ($161,000 in 2024), you’re not eligible for a Roth IRA.
No Immediate Tax Deduction
With a Roth IRA, all of your contributions use after-tax money. Therefore, you won’t get an immediate tax deduction on your income taxes for that year.
Benefits of a Traditional IRA
Here are the advantages of choosing a traditional IRA:
Tax Deductible Contributions
Most people can deduct their contributions on their income taxes each year. This lowers their annual earnings and can reduce how much they pay to the government. Likewise, the money will grow tax-free, so you can delay your tax bill on those earnings until you make withdrawals.
No Income Limit for Contributions
It doesn’t matter how much money you make at your job; you can set up a traditional IRA.
Drawbacks of a Traditional IRA
Though there are some perks, a traditional IRA does come with a few drawbacks. These include:
Required Minimum Distributions
You are required to withdraw your money when you turn 73 years old. The IRS determines the minimum amount using a special formula. Therefore, you can’t save it for later or give it to your beneficiaries.
You saw the tax benefits when you contributed the money, but that perk goes away when you withdraw earnings. Ultimately, you’ll pay taxes on the withdrawals, and it’s considered ordinary income tax.
Eligibility Criteria for a Roth IRA and a Traditional IRA
Let’s focus on the eligibility criteria for both types of IRAs:
Eligibility Based on Income and Age
Roth IRAs do have income restrictions. High earners probably won’t benefit from having one. Likewise, your age plays a part. If you’re early in your career, you’ll have more time until retirement, so you can compound that growth longer.
Be aware that you will have to take distributions with a traditional IRA at 73. Even if you’re working and in good health, you must withdraw contributions. This can be problematic for some.
Deductibility of Contributions
Overall, Roth IRA contributions can be withdrawn tax-free because you pay taxes on the money initially. Alternatively, traditional IRA contributions are taxed upon withdrawal because you deducted them from your income taxes in the year you put money in.
Eligibility for a Roth IRA: Special Considerations
The biggest thing to be aware of with a Roth IRA is how much you earn. If you make over a certain amount, you’re ineligible altogether. However, if you make a little too much, you could be subjected to a reduced contribution limit because of it. This might hurt your earnings and growth later.
Dual Contribution: Roth IRA and Traditional IRA
Can you have both a Roth and traditional IRA? Yes! However, let’s take a look at the potential benefits and drawbacks:
Feasibility of Dual Contributions
It’s feasible to have both types of IRAs and make dual contributions. However, you should remember that the annual contribution limit is for all your IRAs. You can split it up any way you want, but you can’t put $6,500 into both accounts.
Financial Implications of Dual Contributions
It can be tricky to keep track of both types of accounts because they are so different. However, working with a financial advisor and tax professional can help you.
Here are the things to understand about early withdrawals and minimum distributions:
Rules for Early Withdrawals
The consequences of early withdrawals are simple. If you withdraw contributions before 59.5 in a traditional IRA, you will likely get hit with a 10 percent tax penalty and will pay ordinary income taxes on the amount. You can take contribution withdrawals without penalty or tax, though earnings are a different story.
Understanding Required Minimum Distributions
You’re required to take the minimum distribution at 73 with a traditional IRA, though there are no distribution requirements for Roth IRAs.
Choosing the Right IRA for Retirement Saving
It’s important to choose the best IRA, and here are some things to consider in the Roth IRA vs. traditional IRA debate:
Factors Influencing IRA Choice
When dealing with IRA choices, here are a few factors to consider:
- Withdrawal requirements
- After- or before-tax dollars
- Current age
- Family history
Financial Goals and Retirement Plans
Ultimately, you must look at your financial goals for retirement to determine which is best for you. A traditional IRA can be helpful if you plan on being in a lower tax bracket, but a Roth IRA is ideal if you think you’ll be in a higher one.
Income Level and Tax Considerations
Determine what your income level is now and what it might grow to in the future. If you can, a Roth IRA might be ideal, though you’ll pay taxes on the money before it goes into the account.
Recommended Roth IRA and Traditional IRA Providers
There are many companies that offer IRAs. Consider these options:
- Charles Schwab
- J.P. Morgan
Frequently Asked Questions
What Are the 2023 Roth IRA Contribution Limits?
The 2023 contribution limits for a Roth IRA are $6,500 or $7,500 (over 50). For the latest update, read more about the Roth IRA contribution limits for 2024 and onwards.
What Is the Difference Between a Roth IRA and a Traditional IRA?
Traditional and Roth IRAs differ in many ways. Here are the top three:
- You don’t get a tax break immediately with a Roth IRA. However, you’ll get a tax break now with a traditional IRA.
- You see tax-free withdrawals using a Roth IRA, but you’ll be taxed on the contributions with a traditional IRA.
- You don’t have to withdraw money from a Roth IRA, but you’re required to make withdrawals at age 73 with a traditional IRA.
What Are the Benefits of a Roth IRA?
The benefits of a Roth IRA include:
- Tax-free growth and withdrawals
- Never have to withdraw money
- Can withdraw at any time (in most situations)
What Is the Income Limit for a Roth IRA?
Single tax filers require a MAGI under $138,000 in 2023 and $146,000 in 2024. Otherwise, they have reduced contribution limits.
Is It a Good Idea to Convert an IRA to a Roth IRA?
It might be a good idea to convert your traditional IRA to a Roth IRA, especially if you change jobs. You may also convert if you think you’ll be in a higher tax bracket later in life.
In the Roth IRA vs. traditional IRA debate, it’s hard to know which option is ideal for your retirement savings. Today, you learned about the differences between these accounts and can hopefully make a more informed decision.