Roth IRA vs. Traditional IRA

Contributor, Benzinga

If you’re ready to tap into an individual retirement account, you may want to consider a Roth IRA or a Traditional IRA. Both types of individual retirement accounts allow you to invest in stocks, bonds, exchange-traded funds (ETFs) and/or mutual funds, but what differences will you encounter? 

Let’s find out! Don’t forget to check out Benzinga’s Roth IRA vs. 401(k) for more information about these types of investments.

Tax Treatment

Tax treatment between contributions and withdrawals differs between Roth and Traditional IRAs:

  • Roth IRA: Contributions made to a Roth IRA are not tax-deductible. You make Roth IRA contributions with after-tax money, meaning a larger amount of pretax income is needed to match the same contribution amount as with a traditional IRA.
  • 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, which means 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 and/or your spouse are already covered by a retirement plan at work. In this case, your household income and filing status also help determine much of your IRA contribution you can deduct, as determined by IRS rules.

Age Limit Considerations

Roth IRA: A Roth IRA allows you to contribute to contributions at any age, which offers a viable option for investing in later years, and you can still benefit from tax-free withdrawals. 

Traditional IRA: You’re limited to contributing up to age 70½ with traditional IRA. You must begin making withdrawals at that age to comply with IRA rules.

Contribution Limits

Both Roth IRA and traditional IRAs share the same annual contribution limits — the 2021 combined annual contribution limit for Roth and traditional IRAs is $6,000 ($7,000 if you’re age 50 or older). 

This means that not only are the limits the same, the limits are shared between the two types of IRA accounts. In other words, if you have both a Roth IRA and a traditional IRA, the contribution limits are cumulative. 

Contribution Limits by Income Level

Contribution income limits differ between Traditional and Roth IRAs.

Traditional IRA

You can contribute to a traditional IRA at any income level — it’s not based on income. Instead, you’re limited 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. 

Roth IRA

When your income hits a certain level, you may not be able to contribute to a Roth IRA

In 2021, the Roth IRA income limit to qualify for a Roth IRA is $140,000 for single filers and $208,000 for joint filers. Contribution limits are governed by modified adjusted gross income (MAGI). 

Taxes on Withdrawals

Learn more about how Roth IRAs and traditional IRAs differ on taxes for withdrawals and tax breaks. 

Roth 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. 

If you’ve had a Roth IRA for less than five years and you take a distribution, your earnings may be subject to taxes and penalties. You may be able to avoid penalties (but not taxes) in the following situations:

  • A first-time home purchase
  • Qualified education expenses
  • Qualified expenses related to a birth or adoption
  • You become disabled or pass away
  • You pay for unreimbursed medical expenses or health insurance if you’re unemployed
  • Your distribution is made in substantially equal periodic payments

On the other hand, If you’re under age 59½ and you’ve had your Roth IRA for five years or more, your earnings will not be subject to taxes if you meet those same conditions.

Traditional IRAs

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’re taxed based on your tax bracket when you begin to withdraw from your traditional IRA account. IRA balances withdrawn are taxed as regular income, not as capital gains like many other stock or mutual fund investments.

Penalties for Early Withdrawals

Early distributions from IRAs (that is, those made before age 59½) generally incur a 10% tax penalty — you may owe income tax on it as well. The IRS imposes the penalty to encourage you not to use your savings before retirement. However, the penalty only applies if you withdraw taxable funds.

You can withdraw Roth IRA contributions at any time, penalty free.

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 70½, 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 70½ earning income in the year of contribution

Single or head of household: Must earn less than $140,000Married filing jointly: Must earn less than $208,000

Contribution Limits

Up to $6,000 unless you are age 50 or over, in which case it is $7,000.

Up to $6,000 unless you are age 50 or over, in which case it is $7,000.

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 59½. At 70½, 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 59½ 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 70½ — or if you don’t need to tap the balance, you can bequeath the balance of your Roth IRA to heirs. 

A Roth IRA also offers tax-free access to your balance at any age. Check out Benzinga’s Best Roth IRA Accounts for more information.

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When a Traditional IRA Might Be Best

If you anticipate that your tax bracket will be lower when you withdraw from your IRA, then a traditional IRA is likely the better choice. If you consider what your income might be when you reach the mandatory withdrawal age of 70½ or at any age over 59½, 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 100% of your contribution to work. If your tax bracket is low 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.

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When to Use Both

Both traditional and Roth IRAs each have their unique advantages. Some investors use both types of IRAs as part of their retirement investment planning. This strategy provides flexibility and reduces 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 you choose to hedge your bet by using both types of IRAs, be aware that maximum contribution limits apply to the combined contributions for both types of IRAs. If your maximum limit is $6,000, that limit applies to all IRAs you hold collectively.

Choose the Best IRA for You

An IRA is a great option for 401(k) rollovers or for additional retirement investing. The type of IRA you choose — a Roth IRA or traditional IRA — depends on 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 you withdraw from the account.

Because there are tax considerations, it’s always recommended that you consult with your tax professional when choosing the type of IRA to contribute to or when you make large contributions.