With about $5 trillion invested in IRAs, investors continue to favor the individual retirement account above the 401(k) when it comes to total amount invested. That’s at least partly due to the features and limitations of each type of account — and the freedom to invest in an IRA at any age and with any source of funds. The IRA’s popularity also benefits from being a commonly used vehicle for 401(k) rollovers when retirement investors leave or change jobs.
Since 1974, which predates the 401(k) by four years, the traditional IRA has become a mainstay in many retirement portfolios. In 1997, the Roth IRA became another option for retirement investing, providing some advantages over a traditional IRA in some cases.
While IRAs are typically invested in mutual funds, both a Roth IRA or a traditional IRA could be used to hold varied types of investments, including stocks, bonds, mutual funds, annuities, or even real estate. However, it should be noted that real estate held in an IRA cannot be for personal use and that some other types of assets, like life insurance policies, also can’t be held within an IRA.
Check out Benzinga’s Roth IRA vs. 401(k) for more information about the options for both.
Age limit considerations
A Roth IRA allows contributions at any age, providing a viable option for investing in later years while still benefiting from tax-free withdrawals. With a traditional IRA, investors are limited to age 70 ½, at which time they have to begin making withdrawals to comply with IRA rules.
Both Roth IRA and traditional IRAs share the same annual contribution limits, meaning not only that the limits are the same, but that the limits are shared between the two types of IRA accounts. If you have both a Roth IRA and a traditional IRA, the contribution limits are cumulative.
For the 2018 tax year, the current contribution limit is $5,500 if you’re under age 50. If you’re 50 or older, the 2018 contribution limit is raised to $6,500. Bear in mind that at age 70 ½, you can no longer contribute to your traditional IRA. Contributions to Roth IRAs are not limited by age.
Contribution limits by income level
Your contributions to a traditional IRA aren’t limited by your income but are governed by the maximum allowable contributions as determined by the IRS. Both Roth IRAs and traditional IRAs require that you have taxable income in the year you contribute.
When your income hits a certain amount, your Roth IRA contributions could become limited. IRA rules treat this as a phase out as income increases once you reach the lower end of the income range. For example, a married couple filing jointly in 2018 will begin to see their contribution limit reduced at an income of $189,000, and at $199,000, that same couple is not eligible to contribute to a Roth IRA at all. Contribution limits are governed by modified adjusted gross income (MAGI).
Tax treatment of IRAs
The tax treatment of IRAs are what make them attractive to investors, and there are of course two primary aspects of tax treatment:
- Tax deductibility of contributions, and
- Tax treatment on withdrawals.
Contributions made to a Roth IRA are not tax-deductible. Roth IRA contributions are effectively made with after-tax money, meaning a larger amount of pretax income is needed to match the same contribution amount as with a traditional IRA.
A traditional IRA is tax deductible, and you are only taxed when you begin to withdraw from your IRA. A traditional IRA isn’t tax-free — it’s simply tax-deferred, allowing more of your money to be put to work in investments while you pay taxes at a later date, possibly at a lower tax rate.
The amount you’re eligible to deduct with a traditional IRA may be limited if you or your spouse are already covered by a retirement plan at work. In this case, your household income and filing status also help determine how much of your IRA contribution you can deduct as determined by IRS rules.
Taxes on withdrawals
Tax deductibility and the way withdrawals are taxed are the primary differences between Roth IRAs and traditional IRAs.
A Roth IRA, with its after-tax contributions, is not taxed at withdrawal, allowing you to keep 100% of the money from your account. Additionally, you can withdraw from your Roth IRA at any age without paying additional taxes. However, withdrawals before the age of 70 ½ are subject to a 10% penalty, making it clear that Roth IRAs — despite their flexibility — are intended to be retirement investment vehicles.
A traditional IRA is a tax-deferred investment account. You aren’t taxed on the money you contribute until that money is withdrawn from your account. You’ll be taxed based on your tax bracket when you begin to withdraw from your traditional IRA account. Be aware that IRA balances that are withdrawn are taxed as regular income, not as capital gains like many other stock or mutual fund investments.
Penalties for early withdrawals
Both a Roth IRA and a traditional IRA have penalties for early withdrawals of 10% if you take money out before age 70 ½. In the case of a traditional IRA, the withdrawal will also be taxable income at your current tax rate. Roth IRAs are only subject to the 10% penalty if withdrawn before age 70 ½.
Required minimum distributions
Another area where Roth IRAs are different from traditional IRAs is in required withdrawals, called required minimum distributions (RMDs). Once you reach age 70 ½, a traditional IRA requires you to withdraw a certain amount each year.
A Roth IRA has no such limitation, allowing you to leave your money in your account for use later.
|Traditional IRA||Roth IRA|
|Who’s eligible||Anyone younger than 70 ½ earning an income in the year of contribution||Single or head of household: Must earn less than $135,000 Married filing jointly: Must earn less than $199,000|
|Contribution limits||Up to $5,500 unless you are age 50 or over, in which case it is $6,500.||Up to $5,500 unless you are age 50 or over, in which case it is $6,500.|
|Tax benefits||Contributions are tax deductible and withdrawals in retirement are taxed at your income tax rate upon retirement.||Contributions are made after-tax and earnings and withdrawals are tax-free at retirement.|
|Withdrawal rules||Can begin withdrawing money without paying a penalty at 59 ½. At 70 ½, you must stop contributing and must begin withdrawing a minimum amount.||Not required to take a required minimum distribution (RMD) from a Roth IRA; can begin withdrawing money at age 59 ½ without paying a penalty.|
When a Roth IRA might be best
If your tax rate at the time you make your contributions is the same as your tax rate as when you withdraw from your IRA, there isn’t an advantage to either type of IRA in regard to the total after-tax value of your account. However, some situations do create an advantage for a Roth IRA over a traditional IRA.
One case where a Roth IRA could be advantageous would be if you do not foresee a need to withdraw from your IRA. Because a Roth IRA does not have required withdrawals, the entire balance is available without tax or penalties after age 70 ½ — or if you don’t need to tap the balance, the balance of your Roth IRA can be bequeathed to heirs.
A Roth IRA also offers tax-free access to your balance at any age. However, a 10% penalty will still apply to withdrawals prior to age 70 ½.
Check out Benzinga’s Best Roth IRA Accounts for more information.
When a traditional IRA might be best
Traditional IRAs continue to be more commonly used than Roth IRAs, possibly because they are better known and are the type of IRA used for traditional 401(k) conversions. But relative popularity isn’t the only reason to choose a traditional IRA.
If you anticipate that your tax bracket will be lower when you withdraw from your IRA, than a traditional IRA is likely the better choice. If you consider what your income might be when you reach the mandatory withdrawal age of 70 ½ or at any age over 59 ½, when you aren’t subject to the 10% penalty, a traditional IRA may provide tax advantages.
Contributions made within traditional IRA guidelines are usually tax deductible, allowing you to put a hundred percent of your contribution to work. If your tax bracket is low — or even zero — at the time that you need to withdraw, you can significantly reduce the effect of taxes on your IRA balance.
Another case in which a traditional IRA may have an advantage is in the case of 401(k) rollovers. When rolling over a 401(k) into a traditional IRA, there’s no immediate tax consequence. Choosing to roll over to a Roth IRA, however, will make the 401(k) rollover immediately taxable.
Check out Benzinga’s Best IRA Accounts for more information.
When to use both
Because both types of IRAs each have their unique advantages, some investors use both types of IRAs as part of their retirement investment planning. This strategy provides flexibility while also possibly reducing the long-term tax liability on IRA balances. It’s difficult to predict your future tax bracket because income and careers can change unexpectedly.
If choosing to hedge your bet by using both types of IRAs, be aware that maximum contribution limits will apply to the combined contributions for both types of IRAs. If your maximum limit is $5,500, that limit applies to all IRAs you hold collectively.
An IRA is a great option for 401(k) rollovers or for additional retirement investing. What type of IRA you choose, whether a Roth IRA or traditional IRA, depends upon your long-term goals for the account and should also consider your current tax bracket as well as the tax bracket you expect to have when (or if) you withdraw from the account.
Because there are tax considerations, it’s always recommended that you consult with your tax professional when choosing which type of IRA to contribute to or when making large contributions.