IRAs can be valuable to your overall retirement plan due to their tax advantages. For the most part, all you need is taxable income to get started. So, how do you decide which is best?
While there are several types of IRAs, the most common are Roth IRAs and traditional IRAs. The major difference between the two types of accounts is when your contributions and earnings are taxed. Other differences include contribution and income limits, as well as age requirements and withdrawal penalties.
Let’s walk through the perks and downsides of a Roth IRA and traditional IRA so you can make the right decision for your financial future.
A traditional IRA is an individual retirement account (IRA) to which you can contribute pre-tax dollars. Your money can grow tax-deferred, but you’ll pay ordinary income tax on your withdrawals. There are no income limitations for a traditional IRA.
You must start taking distributions after age 72. You may want to consider putting money into a traditional IRA if you feel that you’ll fit into a lower tax bracket in the future.
In 2022, you can contribute a maximum of $6,000 per year to a traditional IRA. You can contribute $7,000 per year if you’re 50 or older.
You can withdraw money from your traditional IRA after age 59 ½. If you pull money out early, you may have to pay a 10% penalty in addition to ordinary income taxes except for in certain circumstances:
- First-time home purchase: If you’re making a first-time home purchase, you may be able to use traditional IRA funds if you use them within 120 days of withdrawing the money for a home purchase.
- Birth or adoption expenses: If you have birth or adoption expenses you can withdraw money from your traditional IRA without penalty.
- Qualified educational expenses: You can use traditional IRA funds to pay for qualified education expenses, such as tuition and room and board fees.
- Disability or death: If you suffer a disability, you can withdraw IRA funds without penalty. If you pass away, your beneficiaries can withdraw funds from your IRA without penalty as well.
- Medical expenses: Unreimbursed medical expenses that are more than 7.5% of your adjusted gross income (AGI).
- Health insurance: Upon finding yourself unemployed for at least 12 weeks, you can use traditional IRA funds to pay for health insurance for yourself, a spouse and/or your dependents.
- Periodic payments: If you choose to receive your funds on a regular distribution schedule, you can avoid an early withdrawal penalty.
- Reservist distributions: National Guard and reservists can take penalty-free distributions if in active duty for at least 180 days, though it’s important to look at the specific rules for this option.
A Roth IRA is an individual retirement account into which you contribute after-tax dollars from earned income, unlike a traditional IRA, in which you contribute pre-tax dollars. The benefit is that you enjoy tax-free growth on your investment. In other words, you don’t have to pay tax on the money when you withdraw it in retirement as long as you follow the withdrawal rules.
Just like a traditional IRA, you can contribute $6,000 in 2022 ($7,000 if you’re 50 or older), but it’s important to know that you can contribute a combined limit of $6,000 (or $7,000) if you invest in both Roth and traditional IRAs.
To qualify, you must fall into specific income ranges. Your contribution can be phased out (reduced) as your modified adjusted gross income (MAGI) approaches the following upper limits. Once you hit the top range, you cannot contribute at all:
Roth IRA Qualification Table
|Filing Status||2022 Income Range|
|Single||$129,000 to $144,000|
|Married, filing jointly||$204,000 to $214,000|
|Married, filing separately||$0 to $10,000|
You may withdraw money after age 59½ after a five-year holding period. If you take a distribution of Roth IRA earnings before age 59½ and before you’ve had the money in the account for fewer than five years, your earnings may be subject to taxes and penalties.
Like a traditional IRA, you may not be subject to a withdrawal penalty for a first-time home purchase, qualified educational expenses, disability or death, unreimbursed medical expenses, health insurance for unemployment and birth or adoption expenses.
Withdrawals from a Roth IRA you’ve had less than five years means your earnings will be subject to taxes but not penalties. If you’ve met the five-year holding requirement, you can withdraw your money from a Roth IRA with no taxes or penalties. With a Roth IRA, there are no required minimum distributions (RMDs).
Difference between Roth and traditional IRA
Here’s a quick rundown of a few of the differences between Roth and traditional IRAs:
- Tax deductions: A Roth IRA doesn’t offer tax deductions on contributions and interest in a Roth IRA is tax-free. Traditional IRAs do offer tax deductions on contributions; interest earned in a traditional IRA is tax-deferred until you take it out in retirement.
- Income limits: Income limits are imposed for Roth IRAs but not for traditional IRAs.
- Distributions and withdrawals: You can withdraw your Roth IRA contributions at any time. However, you can only pull the earnings out of a Roth IRA after age 59 ½, after owning the account for at least five years. Withdrawing that money earlier can trigger taxes and a 10% early withdrawal penalty. Withdrawals of earned interest before age 59½ may be subject to taxes and penalties. Traditional IRA distributions taken after age 59½ are taxed at your tax rate at the time of the withdrawal and may be subject to a 10% penalty.
- RMDs: You don’t have to take RMDs for a Roth IRA but with a traditional IRA, you must begin taking required minimum distributions at age 72.
Compare Roth and Traditional IRAs Side by Side
The major difference between the two types of accounts is when your contributions and earnings are taxed. Other differences include contribution and income limits.
Compare and contrast the qualities of traditional IRAs and Roth IRAs using this chart for a basic overview of the two types of accounts. Understanding these key concepts can help you determine which IRA makes the most sense for your situation.
Roth and Traditional IRA Comparison Table
|Roth IRA||Traditional IRA|
|Tax benefits||No tax deduction on contributions
Interest earned in the IRA is tax-free.
|Tax deduction on contributions
Interest earned in the IRA is tax-deferred until you take it out in retirement.
|Contribution limits||$6,000 age 49 and younger; $7,000 age 50 or older||$6,000 age 49 and younger; $7,000 age 50 or older|
|Income limits||Income affects how much you can contribute. Learn more about the current limits.||Income does not affect how much you can contribute.
Income (and whether you have an employer-sponsored retirement plan) can affect deduction amounts.
|Age requirements||Contribute at any age||Contribute at any age|
|Distributions||Take your contributions out at any time without paying additional tax or a penalty; you can take earnings out without tax or penalty once you are 59½ or older (if the money has been in the IRA for at least five years).||Distributions taken after age 59½ are taxed at your tax rate at the time of the distribution.|
|Required minimum distributions||No mandatory withdrawals during your lifetime||You must begin taking required minimum distributions at age 72.|
|Early withdrawal penalties||Withdrawals of earned interest before age 59½ may be subject to taxes and penalties.||Withdrawals made before age 59½ are taxed at your tax rate at the time of the withdrawal and may be subject to a 10% penalty.|
Can you contribute to both Roth and traditional IRA?
If you meet eligibility requirements, you can contribute to both a Roth and a traditional IRA at the same time as long as you don’t exceed the combined annual contribution limit of $6,000 ($7,000 if you’re age 50 or older).
Which is better for you — a Roth IRA or a traditional IRA?
You can’t contribute to a Roth IRA if your income exceeds government-set limits, so if that’s the case for you, your decision is already made.
If you’re trying to decide between the two, consider where you are in your career. A Roth IRA could make sense for you if you’re just starting out. Since you pay taxes up front, you don’t pay taxes on your withdrawals in retirement and you can benefit from years of tax-free growth, since the earnings in a Roth IRA are tax-free.
On the other hand, a traditional IRA could make sense if you are closer to retirement or if you expect your income to be significantly reduced when you stop working. That’s because you get a tax deduction on your contributions right away but pay taxes later on your withdrawals.
Pros and Cons of Traditional and Roth IRA
What are the pros and cons of traditional and Roth IRAs? Let’s walk through the benefits and downsides of both, side-by-side.
Pros of Traditional and Roth IRAs
Traditional and Roth IRAs each offer the following benefits:
- Tax-free growth: Once money is in a traditional IRA, you won’t pay taxes on dividends or capital gains until you withdraw the money. You pay pre-tax for a Roth IRA, which means you don’t pay taxes at all when you withdraw the money.
- Other tax benefits: You can deduct traditional IRA contributions, determined based on income and your tax filing status.
- Exceptions to pulling out money early: Again, you might have to pay a 10% penalty in addition to ordinary income taxes except for when making a first-time home purchase, for birth or adoption expenses, for qualified education expenses, disability or death, medical expenses, health insurance, receiving funds on a regular distribution schedule and for National Guard and reservists if on active duty.
Cons of Traditional and Roth IRAs
The downsides between a traditional and Roth IRA include the following:
- Contribution limits: You’ll have to abide by strict contribution limits with both Roth and traditional IRAs. Your maximum contribution limit is $6,000, with a $7,000 limit if you’re age 50 or older.
- Income limits: If your modified adjusted gross income (MAGI) goes over a certain level, you might not be able to invest in a Roth IRA.
- Penalties: You’ll face a 10% penalty on top of the taxes owed for any withdrawals before age 59½ with a traditional IRA. On the other hand, you can withdraw a sum equal to your contribution’s penalty and tax-free at any time with a Roth IRA (though you will save yourself from the 10% penalty if you’ve held the account for five years and have reached age 59 ½).
- RMDs: You must take required minimum distributions at age 72 with a traditional IRA. If you don’t take the RMD, you’ll pay a 50% penalty, plus taxes.
Once you have a basic understanding of the difference between a Roth and traditional IRA, it’s a good idea to visit the Internal Revenue Service website for specific, up-to-date information. In addition, a tax professional can help you get the right mix of retirement savings products for your situation and life expenses and help you decide between a traditional or Roth IRA.
Let Ally help you get started in the right direction.