The traditional IRA and the Roth IRA are popular savings vehicles for retirement, mainly because each individual retirement account has tax advantages that allow your investments to grow at an accelerated rate when compared to ordinary taxable accounts. This can be a great boon for retirement savings.
But what’s the difference between a Roth IRA and a traditional IRA, and which one is right for you? The answer to that question will depend on how their features help or hinder your unique situation. Which IRA you choose, and how much you can contribute, will depend in large part on the following factors:
Difference Between Traditional and Roth IRA
Roth IRAs and traditional IRAs are taxed differently. Contributions to a Roth IRA are made with after-tax funds. These contributions are then allowed to grow tax-free. Most importantly, all earnings and capital gains can be withdrawn tax-free from a Roth IRA upon retirement. You could theoretically make $10 million on your Roth IRA investments, and not have to pay a penny in taxes when you withdraw the funds.
Conversely, traditional IRA contributions are tax-deductible in the year when you make them. You can deduct these contributions from your total income, thereby lowering your tax liability. Similar to Roth IRAs, traditional IRAs grow on a tax-deferred basis until retirement. However, unlike Roth IRAs, you will pay regular income tax on any traditional IRA withdrawals.
A traditional IRA provides you with tax benefits now, and a Roth IRA gives you tax benefits when you retire. Some people prefer the certainty of paying today’s tax rates instead of waiting to see what the future may bring. These people may prefer to invest in a Roth IRA.
Conversely, others prefer to have additional tax deductions before retirement. These investors may believe that taxes will be lower after their retirement, since their income level at that age will be much less, implying a lower tax bracket. These people may prefer to invest in a traditional IRA. If you are confident that your IRA will make significant earnings, a Roth IRA might be the best choice for you, because all of these earnings can be withdrawn tax-free.
2. 70 1/2 Rule and Required Minimum Distributions
You must start taking withdrawals from a traditional IRA by April 1st of the year following the year when you turn 70 1/2. These are referred to as required minimum distributions, or RMDs, and are calculated annually based on your age and account balance. The IRS requires RMDs as a way to prevent you from permanently shielding your traditional IRA funds from taxes.
These distributions are calculated so that you will have withdrawn roughly your entire account balance within your lifetime, without exhausting the account. If you’re looking for a retirement account in which you can let funds grow tax-free for as long as you want, a Roth IRA might be a better choice for you. Since the Roth IRA has no RMD requirement, you can leave funds in the account until you need them, or transfer them to your heirs.
3. Early Withdrawals
Withdrawals are generally considered “early” if taken before you reach age 59 1/2. Early withdrawals for Roth IRA earnings and all funds within a traditional IRA, including contributions and earnings, are subject to both taxes and a 10% penalty.
On the other hand, income tax has already been paid on Roth IRA contributions, so these can be withdrawn at any time, including prior to retirement, without additional taxes or the 10% penalty, with some exceptions. Both the Roth and traditional IRAs will waive the 10% penalty for the following withdrawals:
- To pay for medical insurance premiums after losing your job.
- If medical expenses exceed 7.5% of your AGI (adjusted gross income).
- If you become totally and permanently disabled.
- If withdrawn by your beneficiary in the case of your death.
- If you incur qualified higher education expenses.
- If withdrawals are used to build, buy, or remodel a first home – up to $10,000.
- If you are a qualified reservist.
- As part of a series of substantially equal periodic payments, or SEPP plan.
In addition, if a Roth account is open and funded for at least five years, and the withdrawal is due to disability, death, or for a down payment on a house, taxes will also be waived on the funds withdrawn.
If you foresee a need to withdraw funds from a retirement account before you turn 59 1/2, a Roth account may be the best choice for you because contributions can be withdrawn tax and penalty-free.
4. Contribution Limits
You can’t contribute to a traditional IRA once you turn 70 1/2. You can continue to contribute to a Roth IRA as long as you’re still working, regardless of age. The amount you can contribute does not differ between accounts. If you’re less than 50 years old, you can contribute a maximum of $5,000 to one IRA, or a combined total of $5,000 to both a Roth and a traditional IRA. If you’re older than 50, this limit increases to $6,000. This is because the IRS allows you to deposit “catch-up” contributions so that individuals nearer retirement age can accumulate more savings faster and make up for not contributing the full amount in years past. This “catch-up” provision applies to both the Roth IRA and the traditional IRA.
These days, many people are working well past the traditional retirement age of 59 1/2, and they also need their retirement savings to grow for a longer period of time. The ability to extend tax-free growth in a Roth IRA beyond age 70 1/2 can be quite valuable, especially for individuals who haven’t saved enough for retirement.
5. Earned Income Limits
There are limits to how much you can deduct from a traditional IRA, or how much you can contribute to a Roth IRA, depending on your modified AGI. If your income is less than the lower end of the appropriate range below, you can deduct or contribute the maximum annual amount to the account.
Keep in mind that you can still contribute to a traditional IRA if your income exceeds these limits, but you can’t deduct your contributions. If you exceed the income limit for a Roth IRA, you are not allowed to make any Roth contributions. For both types of IRAs, the deduction or contribution amount begins to decrease once your income reaches the lower limit, and phases out completely once the upper limit is reached.[table “12” not found /]
If your AGI falls within the phase-out limits above, see IRS Publication 590 to specifically determine how much you’re allowed to contribute to a Roth IRA, or how much of a traditional IRA contribution you can deduct from your taxes. Contribution limits are more generous for a Roth IRA, so this account might be a better choice for investors with higher incomes. If you see your income exceeding these limits in the future, you may want to contribute to a Roth IRA while you’re still eligible, or to a traditional IRA while you can still deduct your contribution.
6. Rollovers and Conversion
A rollover is when funds are transferred from a retirement account, such as a 401k or 403b, to a traditional or Roth IRA. Since most employee retirement accounts are pre-tax, many people choose to rollover funds into a traditional IRA to avoid paying tax on the entire amount. Rollover amounts to a traditional IRA are not taxed.
As an alternative, most pre-tax retirement accounts, like the 401k, can also be rolled directly into a Roth IRA, but you will need to include the amount as part of your income on your taxes that year. The Roth IRA can be a good choice for small rollover amounts, and for those who are in a low tax bracket, or who can afford the tax bill. There is currently no income limit to roll over any amount to a traditional IRA or a Roth IRA. Check with the financial institution that will be administering your plan for current IRS tax treatment of rollovers.
A separate option is to convert all or part of an existing IRA account to a Roth IRA. A conversion is very similar to a rollover except that the term applies to changing a traditional, SEP, or SIMPLE IRA account, into a Roth IRA. For example, when funds from an old 401k are moved into a Roth account, the move is called a rollover. When you want money in a traditional IRA moved to a Roth, you convert the funds.
As of 2010, the income limit on conversions has been lifted and there are no income limitations. These new rules have been a boon to people who would have been otherwise ineligible for the Roth IRA. People who are ineligible for a Roth IRA can instead contribute the maximum amount for a set number of years to a “non-deductible” traditional IRA, and then convert the funds to a Roth.
In other words, even if your income level is too high to open a Roth IRA, you can still convert assets to a Roth. Keep in mind that un-taxed contributions and earnings that are converted to a Roth IRA must be reported as ordinary income during the tax year they are converted. It’s unclear when or if Congress will revert to the previous income limitations or establish a new limit for Roth IRA conversions.
The Roth IRA and the traditional IRA have different implications for tax planning, estate planning, access to funds, and eligibility. To determine which account is right for you, consider these questions:
- How do you feel about taxes?
- Would you prefer to pay them now, or during retirement?
- Do want the ability to leave funds untouched during retirement, or to pass on a tax-free account to your children?
- Do you think you’ll need to dip into your retirement account early?
- Is your AGI high enough that you can’t deduct traditional IRA contributions, but can still contribute to a Roth?
One distinct advantage to the Roth is that you don’t have to worry about future tax rates, and you will know exactly what you have to work with upon retirement.
What are the advantages and disadvantages of Roth IRAs vs. traditional IRAs? Which are you utilizing for your retirement savings?