Individual Retirement Accounts (IRAs) are among the most popular tools when saving for retirement. Both Roth and traditional IRAs are powerful retirement strategies, and both accounts offer tax advantages in different ways. Understanding how they work, how they compare, and which one fits individual needs can help make a retirement strategy stronger and more personalized. Using a mix of both accounts often gives them the best of both worlds.
What They Are
A traditional IRA account allows individuals to contribute pre-tax dollars toward retirement savings. This means the money they put into their IRA can help lower their taxable income for the accounting year. However, this is also based on the individual’s income and whether or not a retirement plan at work covers them.
On the other hand, a Roth IRA is funded with after-tax dollars. This means contributions to the system do not come with tax breaks. Despite that, the contributions still grow tax-free. Additionally, individuals can later withdraw during retirement without paying taxes, provided they meet set criteria.
Both accounts’ core purpose is to help individuals save for retirement. The difference lies in how the two accounts are structured and how they impact the long-term outcomes.
Key Differences
The biggest difference between the two accounts is based on when one needs to pay taxes. With a traditional IRA account, the tax deductions are delayed until the account holder reaches the age of 59 and a half years old. This is also when they start taking distributions from the account. It can help individuals who are in a lower tax bracket when they retire.
With Roth IRA accounts, individuals with higher tax rates on their retirement income gain higher benefits. Since they are already paying taxes, their withdrawals later are not taxed. This is a huge advantage at a later age. Younger individuals who start investing early on are the biggest beneficiaries of the system and can expect to earn more as they age.
Another notable difference between the two IRA accounts is how each handles required minimum distributions. Traditional IRA accounts require distributions from the age of 72 or 73 years. Roth IRA account holders have more flexibility in this matter, as there are no minimum distribution requirements for the original account holder. Roth IRAs, therefore, provide individuals with better control over when and how they use their funds.
Contributions and Income Rules
Traditional and Roth IRAs have a set limit of $7,000 annual contribution. However, based on the catch-up contribution rule, individuals aged 50 or older need to contribute $8,000 annually.
Of the two types, only the Roth IRA has an income limit applicable to it. High earners have limited ability to contribute to a Roth IRA account. As they start earning more, their contributions start phasing out. Individuals who are single and filing for a Roth IRA have a phase-out limit starting at around $146,000 and ending at around $161,000. Alternatively, married couples filing for the account have different phase-out limits. The joint filing phase-out begins around $230,000 and goes up to $240,000.
Individuals who invest in traditional IRAs do not have to worry about contribution limits. However, deduction limits may be based on the contributors’ workplace coverage. If an individual has workplace retirement coverage and makes more than a certain amount, they might have limited withdrawals.
Withdrawal Rules and Penalties
Traditional IRAs allow withdrawals after the age of 59 and a half years. However, if individuals need to withdraw before that threshold, they are subject to a 10% penalty. In addition, they also have to make regular income tax payments unless they qualify for some exception. Once an individual reaches retirement age, the retirement distributions are regarded as ordinary income and taxed accordingly.
Roth IRAs are more flexible in this matter. Contributions made to the account can be withdrawn at any time without concern for taxes or penalties. However, the withdrawal must come from contributions, not earnings deposited in the account. For contributors to make tax-free withdrawals from their earnings, the account must be at least five years old. Alternatively, they need to meet specific criteria, such as buying a first home, being older than 59 and a half, or becoming differently abled. This flexibility makes Roth IRAs appealing to those who want an emergency backup or plan to retire early.
What to Choose
Choosing between the two IRA accounts involves more than just tax considerations. Individuals need to evaluate factors such as flexibility, timing, and financial goals.
A Roth IRA account is beneficial for those who want reduced tax burdens. It also helps them avoid RMDs (required minimum distributions). Original Roth IRA account holders can even pass on the money tax-free to their families. With this account, individuals maintain some control over their taxable income in their retirement.
Traditional IRAs, on the other hand, are better for those currently looking for a tax break. This type of account is a preferred option for those who do not mind their income significantly going down during their retirement. It can also complement other accounts well, especially when trying to lower adjusted gross income for tax purposes.
Individuals can contribute to a Roth and a traditional IRA in the same year. They just need to make sure their contributions don’t exceed the annual limit. This approach, called IRA diversification, allows individuals to split their retirement savings across different tax strategies. Some financial advisors even recommend such an arrangement to help hedge against future tax uncertainty. Speaking to a financial advisor can help determine which account is best for the individual.
