Roth IRA vs. Traditional IRA

Roth IRA vs. Traditional IRA

The goal of an Individual Retirement Account (IRA) is to build a nest egg for post-career years through the use of intelligent and tax-advantaged investments over time. Employers offer some IRAs, but two of the most common are designed for personal use.

These are the Roth and traditional IRA.

The most significant difference between a Roth IRA vs traditional IRA is when you can utilize the account’s tax benefits. There are also some key variations, such as qualifying requirements, when money can be taken without penalty, and whether you’ll be obliged to withdraw cash according to the government’s schedule in the future.

To better understand how each operates, let’s look at some of the significant differences between a Roth and a traditional IRA.

What Is a Traditional IRA?

A traditional IRA enables individuals to invest pretax income in tax-deferred investments. Dividends and capital gains are not taxable until the beneficiary withdraws them. Your donation may also be tax-deductible, depending on your income.

Deferring taxes allows for greater wealth building. Beginning in the tax year 2020, the Setting Every Community Up for Retirement Enhancement Act (SECURE Act) eliminates the maximum age limit for Traditional IRA contributions as long as you or your spouse, if filing jointly, has earned income.

What Is a Roth IRA?

Roth IRAs provide tax-free growth. If you meet a five-year waiting period and are at least age 59½, or if you die, become disabled, or use the first-time homebuyer exception, your investment gains are received tax-free in retirement. No tax deduction is available regardless of income because Roth IRA contributions are made with after-tax dollars.

You may contribute at any age provided that you or your spouse (filing jointly) has earned income and your modified adjusted gross income (MAGI) does not exceed certain limits.

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Key Differences of a Roth vs. Traditional IRA

The most significant distinction between a Roth and a traditional IRA is how and when you receive a tax benefit. Traditional IRA contributions are tax-deductible, but withdrawals after retirement are taxed. On the other hand, contributions to Roth IRAs are not tax-deductible, but withdrawals in retirement are tax-free.

The following are the primary distinctions between traditional and Roth IRAs:

ROTH IRA TRADITIONAL IRA
Contributing does not provide a tax benefit immediately Contributions are tax-deductible in the year they’re made
You can withdraw contributions at any time without paying taxes or penalties. Withdrawing earnings may cause a penalty if you don’t qualify for an exemption. Based on an individual’s income, deductions may be phased out
At higher incomes, the ability to contribute gradually decreases Retirement distributions are taxable as ordinary income starting at age 59 ½. Prior to that, you may face a penalty unless you qualify for an exemption.
Tax-free withdrawals are permitted during retirement Upon reaching age 72, required minimum distributions (RMD) are due

IRA Eligibility

Eligibility for individuals hoping to open either a traditional or Roth IRA account differs.

Traditional IRAs

If you (or your spouse) have taxable income and are under the age of 70½, you can contribute to a traditional IRA.

Roth IRAs

Due to income restrictions, high-earners cannot open and contribute directly to a Roth IRA. The following are the Roth IRA income limits for 2021:

  • If a married couple filing jointly or a qualifying widow(er) has a combined income of more than $208,000, they are not eligible.
  • Individuals who are single or head of household, or who are married and filing separately (and have not lived with a spouse throughout the year): If their adjusted gross income exceeds $140,000, they are ineligible.
  • Separately filed taxpayers who lived with their spouses for any part of the year are ineligible if their MAGI is over $10,000.

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How to Contribute and Withdraw From an IRA

Here’s what you need to do to contribute and withdraw from a traditional IRA vs Roth IRA.

Traditional IRA

To contribute to an IRA, you (or your spouse) must generally have earned income. Even if you’re contributing to a 401(k) or other workplace savings plan, you can contribute $6,000 per year in 2021 and 2022 ($7,000 if you’re 50 or older). You can also contribute to your IRA by transferring funds from another retirement account.

Taxes apply to withdrawals and distributions from your traditional IRA, including deductible contributions. Early withdrawals could be taxed as income and subject to a 10% penalty.

Roth IRA

The account holder can keep the Roth IRA permanently. Unlike 401(k)s and traditional IRAs, there are no required minimum distributions (RMDs) during their lifetime.

Roth IRAs can be funded in a variety of ways:

  • Regular contributions
  • Spousal IRA contributions
  • Transfers
  • Rollover contributions
  • Conversions
Related:What Is a 401k?

You must contribute to Roth IRAs in cash (including checks and money orders). Contributions in the form of securities or property are not permissible. The funds can be invested in various options once they have been contributed, such as mutual funds, stocks, bonds, ETFs, CDs, and money market funds.

Contributions to Roth IRAs can be withdrawn tax and penalty-free at (almost) any time because they are financed with already-taxed funds.

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Traditional IRA Pros and Cons

Wondering what you need to know about traditional IRAs? Here are the pros and cons.

Pros of the Traditional IRA

  • You could qualify for a tax deduction — The primary benefit of contributing to a traditional IRA is immediately saving money on taxes. Depending on your income, you may be able to deduct your contributions from your taxable income each year, lowering your annual earnings and lowering your tax liability.
  • You may be able to delay your tax bill — You won’t have to pay taxes on that money while it’s growing. When you start withdrawing money in retirement, you’ll only pay taxes on money that hasn’t been taxed before. This includes any contributions you were able to deduct on past tax returns, as well as investment earnings.

Cons of the Traditional IRA

  • The tax benefits won’t last forever — You may have had tax breaks when you were younger, but such benefits don’t stay indefinitely. On the back end, you’ll pay the taxman. Thus the government receives a portion of your withdrawals as well.
  • A traditional IRA requires you to start taking some money out — Withdrawals are mandatory once you reach the age of 72. The IRS uses a formula that considers your account’s current value and life expectancy to establish the minimal amount.
  • Early withdrawal may result in penalties — When you withdraw money too soon, it counts in your taxable income, and you may have to pay an additional 10% penalty. There are some exceptions, such as using the funds to pay for medical expenses, hardships caused by unemployment, or down payments on a first home. However, these funds should only be used as a last resort.

Roth IRA Pros and Cons

Below is a summary of the pros and cons to consider when deciding if a Roth IRA is an appropriate investment vehicle for you.

Pros of a Roth IRA

  • Roth IRA withdrawals are tax-free — A Roth IRA provides you with the significant benefit of tax-free growth because you pay taxes on your contributions upfront. No further taxes are levied on the earnings.
  • Nothing ever needs to be withdrawn — There is no compulsion to take money out of a Roth IRA at any age. Instead, you may leave this money in for a more extended period, or you could leave it in forever and bequeath it to an heir or a charity.
  • If you withdraw your contributions early, there is no penalty — Roth IRA withdrawals are not subject to early withdrawal penalties since you have already paid taxes on your contributions.

Cons of a Roth IRA

  • The benefits you receive are not immediate — The Roth IRA lets you contribute after-tax income, so you won’t receive any tax benefits immediately.
  • Withdrawing premature money may seem convenient — It may be handy to access your retirement assets, but it is not a sensible decision. Withdrawing such funds early is a one-way street. You will receive no additional contributions to compensate for any money you take out in the future.

Roth IRA vs Traditional IRA: Which One Is Right for You?

Most Roth IRA vs. traditional IRA advice starts with a question: Do you expect your tax rate to go up or down in the future?

If you can firmly answer that question, you can theoretically choose the sort of IRA that will save you the most money on taxes.

  • Choose a Roth IRA and its delayed tax benefit if you expect a higher tax rate in retirement.
  • If you predict reduced rates in retirement, a traditional IRA with its upfront tax benefit is the way to go.

Whether you choose a standard IRA or a Roth IRA to invest your money, it’s critical to examine choices for diversifying your investments in a way that suits your risk tolerance and retirement timeline.

Look for firms that equip you with a comprehensive spectrum of educational materials on the market and prospective places to grow your money if you want to have complete control over your investment decisions.

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