One of the most common dilemmas taxpayers face when planning for retirement is whether to opt for a Traditional IRA or a Roth IRA. Both have their unique advantages and characteristics which makes this decision a crucial one. Our detailed guide outlines the key differences between Traditional and Roth IRAs, helping you make a well-informed decision.
What are Traditional and Roth IRAs?
The Individual Retirement Account, abbreviated as IRA, is a tax-advantaged account that allows individuals to save for retirement. The IRA comes in two forms: Traditional and Roth. The Traditional IRA offers upfront tax deductions, with investments growing tax-deferred until withdrawn in retirement. The Roth IRA, on the other hand, is funded with after-tax dollars; however, the investments grow tax-free and withdrawals in retirement are tax-free.
Tax Treatment of Contributions
In a Traditional IRA, contributions might be tax-deductible in the year they are made. The exact amount you can deduct depends on your income, tax filing status, and whether or not you or your spouse (if filing jointly) are covered by a workplace retirement plan. In a Roth IRA, contributions are not tax-deductible, they are made with after-tax dollars. While this may seem less beneficial, it actually creates a unique advantage, as discussed in the section about retirement withdrawals.
Tax Treatment of Withdrawals
With Traditional IRAs, withdrawals in retirement are taxed as ordinary income. This is based on the premise that contributions were made pre-tax. In contrast, Roth IRA provides tax-free withdrawals in retirement since the contributions were made with post-tax income. This can be hugely advantageous, especially if you anticipate being in a higher income tax bracket upon retirement.
Traditional IRAs do not have income limits for making contributions. However, high earners may not be allowed to deduct their entire contribution if they or their spouse have a workplace retirement plan. Roth IRAs have income limitations, meaning high earners might not be eligible to contribute. These income limitations change year-to-year and are adjusted for inflation.
Required Minimum Distributions (RMDs)
Traditional IRAs require minimum distributions starting at age 72 (or 70½ if you turned 70½ in 2019 or earlier), regardless of whether or not you actually need the money. Any undistributed amounts can result in a 50% tax penalty. In contrast, Roth IRAs do not require minimum distributions during the owner’s lifetime, providing a significant advantage for those hoping to leave a portion of their IRA assets as an inheritance to their heirs.
If you need to access your savings before reaching 59½, both Traditional and Roth IRAs have rules related to early withdrawals. Usually, an early withdrawal is subject to a 10% penalty in addition to income tax. However, Roth IRAs offer a bit more flexibility by allowing penalty-free withdrawals of contributions at any time. Additionally, Roth IRAs offer some exceptions where earnings can be withdrawn penalty and tax-free.