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Retirement Planning

What's the difference between a Roth IRA and a traditional IRA?

So you're ready to start an IRA. But what kind of IRA do you need? This article outlines the two major IRA choices, their differences and what benefits they offer.

When it comes to saving for retirement, you can never start too soon. An individual retirement account (IRA) is an excellent way to set aside savings for retirement, even if you have a 401(k) or other retirement plan through your employer. 

An individual retirement account (IRA) is a personal savings plan under U.S. tax code law that allows you to set aside money for retirement and offers tax advantages. And while there are many different types of retirement plans to select from, two of the most popular are the traditional IRA and the Roth IRA. But how do you decide what's best for you?

Whether you decide on a Roth IRA, traditional IRA, or both, there are financial implications to consider. Along with IRA basics, the following are some important differences between these two types of IRAs, and other factors to consider when choosing the account that's right for you.

Roth IRA

A Roth IRA is a special type of individual retirement account that is generally not taxed, provided certain conditions are met. Roth IRAs provide no tax break for contributions, but earnings and qualified withdrawals are generally tax-free. So with traditional IRAs, you avoid taxes up to the contribution limit when you put the money in. With Roth IRAs, you can avoid taxes when you take it out in retirement.

Roth contributions (not earnings) can be withdrawn penalty- and tax-free anytime, even before age 59½. Five tax years after the first contribution, you can withdraw up to $10,000 of Roth earnings penalty-free to pay for qualified first-time homebuyer expenses.

All qualified distributions are tax-free, but as with any other retirement plans, non-qualified distributions from a Roth IRA may be subject to a penalty upon withdrawal.

Traditional IRA

With a traditional IRA, you may be able to deduct some or all of your contributions from your taxable income, and may also be eligible for a tax credit equal to a percentage of that contribution. Amounts in a traditional IRA, including earnings, generally are not taxed until distributed. Amounts you withdraw from your IRA are fully or partially taxable in the year you withdraw them.

Contributions to traditional IRAs lower your taxable income in the contribution year. That lowers your adjusted gross income, helping you qualify for other tax incentives you wouldn't otherwise get, such as the child tax credit or the student loan interest deduction. You can withdraw up to $10,000 without the normal 10% early-withdrawal penalty to pay for qualified first-time homebuyer expenses. However, you'll pay taxes on the distribution. You can set up a traditional IRA at any time and make contributions as long as you (or your spouse, if you file joint return) received taxable compensation, such as wages, salaries, commissions, tips, bonuses, or net income from self-employment.

How to choose between a Roth IRA and a traditional IRA

For some, their eligibility to deduct traditional IRA contributions can be the deciding factor in choosing between a Roth and traditional IRA. However, being eligible to deduct your contribution doesn't mean that the traditional IRA is the better choice. Consider whether the benefits of the Roth IRA - such as tax-free qualified distributions - outweigh the benefits of a deduction.

A Roth IRA may be beneficial if you expect to fall in a higher tax bracket when you make withdrawals. A traditional IRA may be beneficial if you are seeking tax benefits in the short-term. You may also select a type of IRA based on the kind of withdrawal flexibility you wish to have. A Roth IRA has no required distribution, whereas a traditional IRA has required distributions once you reach age 73.

Roth IRA vs. traditional IRA

Here's a quick comparison of some of the key differences between a Roth IRA and a traditional IRA.

  • There are certain income limits associated with contributing to a Roth IRA. An individual whose Modified Adjusted Gross Income (MAGI) is under $138,000 for tax year 2023 can contribute to a Roth IRA. Anyone can contribute to a traditional IRA. However, deductibility will depend on your MAGI and filing status. 
  • With a Roth IRA, you can contribute after-tax dollars and can withdraw tax-free after age 59 ½ and a five-year holding period. With a traditional IRA, you contribute pre-tax dollars, which are taxed along with earnings as income upon withdrawal. Both IRAs are subject tax penalties for withdrawals made prior to age 59 ½, except when made under certain circumstances as defined by the IRS.
  • The contribution limit for both types of IRAs is $6,500 in 2023, and $7,500 if you are over 50.
  • With a Roth IRA, contributions grow tax-free, whereas in a traditional IRA, they are tax-deferred.

Can you have a Roth IRA and a traditional IRA?

If you qualify, you may contribute to both a Roth IRA and a traditional IRA. However, keep in mind that the maximum allowable contribution for both is $6,500 or $7,500, if you’re over 50. You have the option of splitting your contribution between both types.

Always consult with a financial professional before determining which option is best for you, your retirement planning and your financial situation. To learn more, visit the IRS website

 

 

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