If you’ve looked for retirement accounts beyond your employer-sponsored plan, you’ve probably heard about an individual retirement account, or IRA.
And if you’re ready to add an IRA to your retirement savings arsenal, that’s great. You’ll be glad you did! But you have to decide which type you’re going to open.
An IRA isn’t an investment itself — it’s an account with special tax advantages.
The most popular types are a traditional IRA and Roth IRA. Both shelter you from certain kinds of taxes; one of the key differences between the two is when you pay taxes on your investments.
As of 2019, you can contribute a maximum of $6,000 annually to an IRA if you’re under 50 and $7,000 if you’re 50 or older. Even if you contribute to multiple types of IRAs, your total contributions cannot exceed these limits.
Both traditional and Roth IRAs penalize you for certain withdrawals before age 59-1/2. The type of IRA that’s right for you might change throughout your career, so it’s important to know the differences between them.
Roth IRA vs. Traditional: What’s the Difference?
The traditional IRA has been around since the ’70s and was created to serve those who didn’t have an employment-based retirement plan.
These are its key features:
- Contributions are sometimes tax-deductible.
- The account is tax-deferred, meaning you’ll pay taxes when you withdraw money.
- Eligibility isn’t limited by income.
The Roth IRA is named after former Delaware Sen. William Roth. It was created to give taxpayers more flexibility with their retirement investing and encourage people to start saving earlier.
Contributions to a Roth IRA are made after-tax, and you can’t deduct them on your taxes.
But because you’re paying your taxes upfront on contributions, you get the unique opportunity to make tax-free withdrawals from your Roth IRA in retirement.
That’s a huge advantage because if you max out your Roth IRA contributions over a few decades, the growth alone could be greater than what you’ve contributed — and you won’t have to pay taxes on any of it.
Here are some of the other differences between a Roth vs. traditional IRA.
Once you turn 70-1/2, you can no longer contribute to a traditional IRA, and you have to begin taking required minimum distributions, or RMDs, which are annual withdrawals.
A Roth IRA has no age limits or mandatory minimum distributions; you can keep it and let it grow forever, then pass it on to someone as long as you’ve had the account more than five years. The beneficiary can then let it grow tax-free, and they won’t pay taxes on withdrawals either — but they will have to take distributions on a timetable.
Speaking of five years: If you open a Roth IRA less than five years away from 59-1/2, you need to wait five tax returns to begin withdrawing earnings tax- and penalty-free. However, withdrawals of contributions are always free of taxes and penalties.
That’s right, you can withdraw your contributions from your Roth IRA at any time for any reason without tax or penalty.
And if you need more, you can withdraw earnings tax- and penalty-free to pay for a first-time home purchase, qualified educational expenses, unreimbursed medical expenses or to cover costs if you become disabled or die.
The penalty for withdrawing earnings before 59-1/2 or before the account has been open five years — whichever comes later — is 10%.
Anyone with taxable income can contribute to a traditional IRA, but a Roth IRA has income limits based on your modified adjusted gross income, or MAGI. (Your MAGI is your gross income minus tax deductions, meaning if you make more than the limit but have enough tax deductions to bring you under it, you’re still eligible to contribute.)
If you’re single, you are eligible to contribute to a Roth IRA if your MAGI is less than $137,000 for the 2019 tax year. If you’re married and filing jointly, your MAGI must be below $203,000.
If you participate in an employer-sponsored retirement plan, like a 401(k) or pension, and you contribute to a traditional IRA, there are limits on how much of your IRA contributions you can deduct. It depends on your filing status and how much money you make.
If you’re married and filing jointly, traditional IRA tax deductions start phasing out at $103,000 MAGI. For singles, deductions start phasing out at $64,000 MAGI.
Roth IRA contributions aren’t tax-deductible.
Factors to Consider Before Choosing an IRA
The traditional IRA is often recommended for taxpayers on the edge of a tax bracket who want to reduce their MAGI and legally pay less in taxes.
The Roth IRA is good for those who anticipate their incomes going up significantly later in life or who are in a relatively low tax bracket now.
The right IRA also depends on how many years away from retirement you are.
If you have a short time before you plan to tap into your IRA, “chances are high the Roth won’t pencil out unless your bracket is very low now and you somehow know your bracket will be much higher once you plan to tap into the money,” said Neal Frankle, certified financial planner at Wealth Pilgrim.
Money you withdraw from a traditional IRA is taxed like any other income because you get the tax deduction benefit upfront.
So if you’re $5,000 under a tax bracket limit and you withdraw $6,000 from your traditional IRA or 401(k), you’ll pay your regular income tax on the first $5,000 and the income tax of the next bracket on that last $1,000.
Because withdrawals from a Roth IRA are tax-free, they won’t push you into a higher tax bracket.
“Since distributions from a Roth IRA are not counted as taxable income, if you have both a Roth IRA and traditional IRA — or 401(k) — during retirement, you can take distributions from a traditional IRA or 401(k) to fill up low-income tax brackets, and then take distributions from your Roth to avoid being taxed at higher tax bracket,” said Matt Hylland, registered investment adviser at Hylland Capital Management.
In the end, the question might not be which IRA should you invest in; it might be which order.
“For those still accumulating assets, I think it makes sense to build up assets in both a Roth IRA and a traditional IRA or 401(k),” Hylland said. “For most, that means prioritizing Roth IRA contributions after maximizing your 401(k) match, if applicable.”
Just because one is right for you right now, that doesn’t mean it’ll always be the right choice. That’s why it’s important to do a checkup on your income and timeline for retirement at the beginning of every tax year.
This article contains general information and explains options you may have, but it is not intended to be investment advice or a personal recommendation. We can’t personalize articles for our readers, so your situation may vary from the one discussed here. Please seek a licensed professional for tax advice, legal advice, financial planning advice or investment advice.
Jen Smith is a former staff writer at Codetic.