Do you want to know the difference between a Roth and traditional IRA? No matter what stage of life you’re in, it’s important to be building a nest egg for retirement.
A general rule of thumb, according to Fidelity, is to have at least:
- 1x your annual salary saved by age 30
- 3x by 40
- 6x by 50
- 8x by 60
- 10x by 67
Putting money into an IRA can help you get there, but which option is best? You’ll get a brief overview of IRA types on this page, plus an in-depth comparison of two of the most popular: Roth vs traditional IRA.
What’s an IRA?
An IRA, short for individual retirement account, is an account set up through a financial institution that allows you to save for retirement on a tax-deferred basis or with tax-free growth. IRAs are one of the most powerful ways to save, plus can often work together or alongside a 401(k) to help you meet your goals.
Quick IRA Comparison of IRAs
There are seven types of IRAs.
- Traditional IRA: Usually the best IRA for those who think they’re in a higher tax bracket now than they will be during retirement as well as those who cannot contribute to an employer-sponsored retirement program.
- Roth IRA: Usually best for those who think they’ll be in a higher tax bracket during retirement than they are now and those who might need to draw funds before retirement.
- SEP IRA: Short for Simplified employee pension; usually best for small business owners who want a retirement plan without paying extra startup and operating costs.
- Nondeductible IRA: Usually best for those who would otherwise go for a Roth or deductible IRA but don’t qualify.
- Spousal IRA: Works for a low-income or nonworking person who is married to someone with earned income.
- SIMPLE IRA: Short for savings incentive match plan for employees; Usually best for small businesses that have less than 100 employees.
- Self-Directed IRA: Usually best for seasoned investors, as self-directed IRAs carry additional risks in exchange for potentially higher returns.
Despite there being seven types of IRAs, most people will opt for either a Roth IRA or traditional IRA, so we’ll focus on those for the rest of this page.
Key Differences: A Traditional IRA vs a Roth IRA
To get started, let’s look at a high-level overview of the differences between a Roth IRA vs traditional IRA.
Eligibility
- Eligibility Requirements for a Traditional IRA: Anyone may contribute to a traditional IRA if they’ve earned U.S. income that year.
- Eligibility Requirements for a Roth IRA: There are income limits for Roth IRA contributors. For example, contributions are phased out for those with an income between $129,000 and $144,000 who are filing as single or head of household in 2022. It’s phased out at $204,000 to $214,000 for those filing as married filing jointly or qualifying widow(er).
Taxes
- Tax Rules for a Traditional IRA: You may be able to deduct all or a portion of your contributions.
- Tax Rules for a Roth IRA: Contributions are never deductible.
Contributions
- Contribution Rules and Limits for a Traditional IRA: The maximum contribution changes annually. For example, those under age 50 have a maximum annual contribution of $6,000, while those over 50 can contribute up to $7,000.
- Contribution Rules and Limits for a Roth IRA: The rules are the same. The maximum contribution changes annually. For example, those under age 50 have a maximum annual contribution of $6,000, while those over 50 can contribute up to $7,000.
Withdrawals and Mandatory Distributions
- Withdrawal Rules for a Traditional IRA: You must begin taking a required minimum distribution at age 72. Earnings withdrawals are taxable, and there are generally penalties for withdrawing before age 59.5. You can withdraw contributions anytime, but deductible contributions are taxable, and you’ll usually pay a penalty if you’re not at least 59.5.
- Withdrawal Rules for a Roth IRA: You’re not required to take a minimum distribution at any age. Certain withdrawals of earnings may be tax-free and penalty-free after the age of 59.5 if you’ve become disabled before that age and for other circumstances. Withdrawals of contributions are not subject to taxes or penalties.
Pros and Cons of a Traditional IRA
Now that we’ve looked at the two most common IRA types side-by-side, let’s do a deep dive into the pros and cons of a traditional IRA.
Benefits of a Traditional IRA
- Anyone with earned income can contribute. Unlike other forms of investment that have caps on income, anyone who has earned income in the U.S. can contribute to a traditional IRA that year.
- Your savings grow tax-free. You aren’t taxed on profits as your investments grow.
- Your contributions are deductible. Because your withdrawals are taxed, anything you add to a traditional IRA isn’t taxed now, so you can deduct it from your income and pay lower taxes now too.
Drawbacks of a Traditional IRA
- Withdrawals are taxable. Since the money you invest should grow, you’ll be taxed more than you would have if you had been taxed before you invested. In retirement, there are tax benefits if you are in a lower tax bracket than you are now, however, it can reduce your savings otherwise.
- A withdrawal penalty applies if you withdraw early and don’t qualify for a withdrawal exception. You’ll pay an extra 10 percent tax penalty if you withdraw before age 59.5.
- Contribution limits are low. Depending on your situation, you might be able to contribute two or three times more with other investment options.
Pros and Cons of a Roth IRA
There are benefits and drawbacks to choosing a Roth IRA too.
Benefits of a Roth IRA
- Your savings grow tax-free. The money isn’t taxed as income until distributed when you retire.
- You can withdraw your contributions at any time. If you’ve added $10,000 to your account, you can withdraw it at any point without penalties.
- There are no required minimum distributions. Other investment options force you to start withdrawing at a certain age.
- Qualified distributions are tax-free. If your account has been open for at least five years and you’re 59.5 or older, there are no taxes or penalties for distribution. If your distributions are not qualified, they’re subject to a 10 percent penalty and may be taxable.
Drawbacks of a Roth IRA
- Those with higher incomes won’t qualify. The cap shifts from year to year, but if you earn more than the average person, you may not be able to contribute to a Roth IRA.
- Contribution limits are low. Roth and traditional IRAs have the same contribution limits, so there’s no disadvantage to going with a Roth IRA vs traditional IRA in this respect. However, you may want to work with other investment options if you need to put more money away.
- Contributions are taxable. Rather than taxing you at distribution, Roth IRA contributions are made after the money has already been taxed. That’s not a bad thing if you’re in a lower tax bracket now than you will be in retirement, but it can eat away at your savings if you’re in a higher tax bracket now.
- Rollovers from your traditional plan are taxable. The entire amount is taxable if you transfer rollover money from your traditional IRA to your Roth.
Should You Choose a Traditional IRA or Roth IRA?
If you’re in a higher tax bracket now than you will be in when you retire, a traditional IRA is generally best.
If you’ll be in a higher tax bracket or think you may need to withdraw contributions before retirement, a Roth IRA is probably the better choice.
With that said, investing for retirement is very personal, and it’s always best to speak with a tax specialist or financial planner to establish which is best for you and how much to contribute to each.
Can You Contribute to Both a Roth IRA and a Traditional IRA?
Yes, you can have both a Roth IRA and a traditional IRA and even contribute to both in the same year if you meet the qualifications. However, they will share the same contribution cap, so having both doesn’t mean you can double your investment. If your goal is to set aside more than the IRA contribution limit allows, you can use other investment vehicles. Employer-sponsored plans such as a 401(k) are one example.
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Disclaimer: This article has not been produced by or vetted by a certified legal or accounting advisor. The information provided in this article may be stale, dated, inaccurate, or not appropriate for reader’s investment purposes. Content of this article should not be relied upon for making any investment decisions. You should seek appropriate counsel for your own situation.
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