Individual retirement accounts or IRAs allow you to gain tax advantages while you save for your retirement.
There are two main types of IRAs: Traditional and Roth. The main difference is the timing of the tax break. With a traditional IRA, you typically pay taxes on your money when you withdraw during retirement–that is, your disbursements are considered income. A Roth IRA is the reverse, where you’ll pay taxes on money when you contribute to the fund, but you’ll avoid paying taxes when you take money out during your retirement.
There are other important differences between the two types, and you should consider them carefully before making a choice.
What do Traditional and Roth IRAs Have in Common?
There are some important features that are common to both traditional and Roth IRAs:
- They are individual plans. Traditional and Roth IRAs are not employer-sponsored retirement plans. You open an IRA on your own with the provider of your choice.
- Contributions are limited. You can contribute to a traditional or Roth IRA at any time in a tax year, but your total annual contribution is limited. If you exceed the limit you will not gain tax advantages.
- The contribution limits are the same. The annual contribution limit for both traditional and Roth IRAs can change from year to year. For 2020 the maximum is $6000 if you are under age 50, $7000 if you are over age 50. If you are contributing to both a traditional and a Roth IRA your combined total annual contribution must not exceed this limit .
- You can invest your funds. Both traditional and Roth IRAs may allow you to invest the funds deposited in your IRA. The available investments will depend on your IRA Provider, so you should check the options a provider offers before opening an IRA.
There are also important differences between Roth and Traditional IRAs.
The Differences Between Traditional and Roth IRAs
Understanding the differences between traditional and Roth IRAs will help you select the right IRA for you. These are the main points to consider.
- Traditional IRA: Your contributions are tax-deductible in the year they made. That lowers your taxable income, which may qualify you for additional tax breaks. When you retire, disbursements from your IRA are taxed as regular income.
- Roth IRA: Your contributions are taxed as income in the year you contribute. You will pay no tax on disbursements of your contributions. Disbursements of investment earnings are tax-free if you are over 59 ½ and you’ve had your account for over five years. If your disbursement does not meet these qualifications your investment earnings will be taxed as regular income.
Restrictions on Contributions
- Traditional IRA: You cannot establish a traditional IRA if you are over age 72. If you have access to a 401(k) retirement plan through your employer your contributions to a traditional IRA may be restricted. There is no income restriction on a traditional IRA.
- Roth IRA: There is no age restriction on a Roth IRA, and you can contribute the full amount to a Roth IRA even if you also have access to a 401(k). If your income is above a certain level your contribution will be restricted, and at a higher level you cannot contribute to a Roth IRA at all. If your income is above the Roth IRA income limit you can consider a backdoor Roth IRA.
Minimum Required Distributions
- Traditional IRA: You will have to take an annual required minimum distribution from your IRA starting at age 72.
- Roth IRA: There is no required minimum distribution at any age. You can keep contributing to your Roth IRA as long as you have earned income. You may leave your Roth IRA to your heirs, and it will still be tax-free.
- Traditional IRA: If you withdraw before age 59 ½ you will pay taxes and a 10% prepayment penalty, except in certain restricted conditions.
- Roth IRA: You can withdraw contributions without tax or penalty at any time. Investment earnings will be taxed as income if you are under 59 ½ years old or if you have had your IRA for less than five years.
These differences produce a number of advantages and disadvantages for both traditional and Roth IRAs. You’ll have to assess what the differences mean to your personal situation before deciding what type of IRA to establish.
Which is Best For You?
The key consideration in choosing between a traditional and Roth IRA is your current tax bracket and the tax bracket you expect to be in when you retire.
- If you expect to have a lower income and move into a lower tax bracket upon retirement, it makes sense to select a traditional IRA and pay the taxes after retirement at a lower tax rate. Remember that you may no longer have deductions for dependents, and you may have taxable income from social security and other sources.
- If you will be in a higher tax bracket when you retire, it makes more sense to select a Roth IRA: you’ll pay tax on your contributions now at a lower rate, but your disbursement will be tax-free.
There are several other considerations:
- If you earn more than the maximum eligible level for a Roth IRA, you will have to set up a traditional IRA or consider a backdoor Roth IRA.
- If you may wish to withdraw funds before retirement, choose a Roth IRA.
- If you plan to use your IRA funds at age 72, a traditional IRA may suit you. If you want to hold them for later in your retirement or potentially leave them to your heirs, consider a Roth IRA.
- If you have access to a 401(k) through your employer and you still wish to establish an IRA, speak to a financial advisor.
If you are funding both a Roth IRA and a 401(k), find out if your employer matches your contributions, and up to what level your contributions will be matched. You will want to prioritize your 401(k) up to the maximum level for employer matching. Your employer’s matching contributions are free money, and you don’t want to leave that on the table!
Consider Funding Both Types
You can maintain both types of IRA at the same time, as long as you meet the eligibility requirements and your combined contribution to the two IRAs does not exceed the annual maximum. If you are setting up a long-term plan to fund your retirement, consider using both.
- Early in your career when you’re in a relatively low tax bracket, concentrate on funding your Roth IRA. The taxes you pay on your contributions will be based on a relatively low rate.
- Later in your career when you’re in a higher tax bracket and your income may exceed your Roth IRA contribution limit, focus on funding your traditional IRA.
- After retirement, you can tap your traditional IRA when required minimum disbursements start at age 72 and hold your Roth IRA in reserve. It will still earn investment income. You can use it later in your retirement or pass it on to your heirs if you don’t need it.
This system takes planning and organization, but it maximizes the value of both types of IRA.
Both traditional and Roth IRAs offer an opportunity for retirement savings with tax breaks and potential investment gains. There are important differences between the two types, and your choice will depend on which features meet your specific needs and expectations. If you’re starting to set up a retirement plan, consider using both, which can diversify your tax breaks and take full advantage of both IRA types. Speak to your financial and tax advisors to figure out what’s right for you.
Disclaimer: The Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.