Traditional IRAs and Roth IRAs are both great ways to boost your retirement savings. Both offer tax advantages you can’t get in a regular, non-retirement investment account, and both will help you reach your long-term savings goals. But there are fundamental tax differences between the two types of accounts. Depending on your current and future tax situations, one account might give you an edge when it comes to total retirement savings. Understanding the ins and outs of both types of accounts can help you decide which one is the better option to maximize your long-term savings.
Here’s what this guide to IRAs versus Roth IRAs will cover:
- Traditional IRA
- Roth IRA
- At a Glance: Traditional IRA vs. Roth IRA
- When Should I Choose a Roth Over Traditional?
- When Should I Choose Traditional Over Roth?
- Where To Find the Best Roth IRAs
- Where To Find the Best Traditional IRAs
- The Bottom Line
Traditional IRA vs. Roth IRA
In many ways, traditional and Roth IRAs are two sides of the same coin. Both provide tax benefits for retirement savings, but they do it in opposite ways. Here’s a breakdown of the Roth vs. traditional IRA comparison examining similarities and differences between the two types of accounts.
What it is: A traditional IRA is a tax-deferred retirement account that offers income tax deductions on certain contributions.
- You’ll get a tax deduction on eligible contributions.
- Earnings grow tax-deferred.
- You’ll owe ordinary income tax on all distributions.
- You’ll face an early withdrawal penalty if you withdraw income or contributions before age 59 ½.
- You must take distributions at least annually once you reach age 70 ½.
- The tax deduction on your contributions might be limited based on your income.
Contributions and earnings within a traditional IRA grow tax-deferred until withdrawn, at which point they are fully taxable. Early withdrawals before age 59 ½ might also trigger an early withdrawal penalty.
If neither you or your spouse are covered by a retirement plan at work, 100% of your contributions to a traditional IRA will be tax-deductible. If you or your spouse are covered by a retirement plan at work, your income might limit the deductibility of your contributions.
You can take money out of an IRA at any time, but you’ll always pay taxes on your contributions and earnings. If you’re under age 59 ½, you’ll also pay an early withdrawal penalty. Required minimum distributions begin once you turn age 70 ½ — although new legislation working its way through Congress, known as the SECURE Act, might raise that age to 72.
Early Withdrawal Penalties
You’ll pay a 10% penalty on any traditional IRA withdrawals you take before age 59 ½, with limited exceptions. You might be able to withdraw up to $10,000 penalty-free for first-time homebuyer expenses, qualified higher education expenses and certain qualifying hardship distributions, such as disability or unreimbursed medical expenses.
You can contribute up to $6,000 to an IRA for 2019, or $7,000 if you’re age 50 or older. Your contribution cannot exceed the amount of your earned income.
Income Requirements and Limitations
You’ll receive a full deduction if you’re married filing jointly with a modified adjusted gross income of up to $103,000, at which point your deduction will begin phasing out. A modified AGI of $123,000 or more results in no deduction. The phaseout range for single filers is from $64,000 to $74,000, and for married taxpayers filing separately, the range is from $0 to $10,000.
Who It’s Best For
A traditional IRA is best for taxpayers likely to be in a lower income tax bracket after retirement. It’s also an appropriate vehicle for taxpayers who want the benefit of a current tax deduction rather than waiting until retirement to enjoy the primary tax benefit.
What it is: A Roth IRA is a tax-deferred retirement investment account that allows for tax-free withdrawals on qualified distributions.
- Eligible withdrawals are tax-free.
- Earnings grow tax-free.
- There are no mandatory distribution requirements.
- There is no age limit on contributions.
- You can withdraw contributions at any time, tax-free and penalty-free.
- You won’t get a tax deduction on your contributions.
- An early withdrawal penalty applies to earnings taken out before age 59 ½.
- There are income restrictions on contributions.
Earnings on contributions grow tax-free within a Roth IRA. Unlike with a taxable investment account, you don’t have to report your income, dividends or capital gains annually to the IRS if they’re within a Roth IRA. Qualified withdrawals are tax- and penalty-free.
You can withdraw your contributions to a Roth IRA at any time without paying any taxes or penalties. But if you withdraw your earnings before you reach age 59 ½, you’ll face ordinary income taxes on those distributions, plus an early withdrawal penalty. Roth IRAs don’t have the required minimum distributions traditional IRAs have.
Early Withdrawal Penalties
Earnings withdrawn before age 59 ½ trigger a 10% early withdrawal penalty. You can avoid this penalty — but not the taxes — in a few situations.
Income Requirements and Limitations
For 2019, you can’t contribute to a Roth IRA if you’re married filing jointly with an income above $203,000. The amount you can contribute is phased out between $193,000 and $203,000 of earnings. For single filers, the income range is $122,000 to $137,000. Taxpayers who are married and filing separately see a low phaseout range of $0 to $10,000 of income.
Who It’s Best For
The Roth IRA is best for taxpayers who anticipate higher tax rates in retirement, for younger investors, and for those who want more flexibility in their retirement account contribution and distribution rules.
|At a Glance: Traditional IRA vs. Roth IRA |
|Traditional IRA||Roth IRA|
|Contribution Limits||2019: The lesser of $6,000 ($7,000 for ages 50+) or the amount of your earned income||2019: The lesser of $6,000 ($7,000 for ages 50+) or the amount of your earned income|
|Pros||Tax deferral of earnings|
Tax deduction on contributions
|Earnings grow tax-free|
Distributions are tax-free
Contributions can be withdrawn without penalty at any time
|Cons||Distributions are taxable|
Tax deduction might be limited based on income
|No tax deduction on contributions|
|Early Withdrawal Rules/Penalties||Withdrawals before age 59 ½ might trigger a 10% penalty||Withdrawals of earnings before age 59 ½ might trigger a 10% penalty|
|Income Limitations||Can only contribute up to the amount of your earned income|
Deductions possibly limited based on income
|Can only contribute up to the amount of your earned income|
Contributions possibly limited based on income
|Required Minimum Distributions||After age 70 ½, must take minimum distributions at least annually||None|
|Who It’s Best For||Savers who anticipate a higher income tax bracket in retirement or who earn too much to contribute to a Roth IRA||Savers who anticipate a lower income tax bracket in retirement|
The No. 1 scenario in which a Roth IRA is preferred over a traditional IRA is if you anticipate being in a higher tax bracket after you retire than while you are working. Because all earnings and contributions to a Roth IRA can be withdrawn tax- and penalty-free after age 59 ½, your net after-tax income will be higher if you’re taking those withdrawals at a time when you’re in a high tax bracket.
Say, for example, you’re in the 15% tax bracket while working but anticipate jumping up to the 22% bracket after you retire, thanks to an influx of income from other sources. If you contributed $1,000 to a traditional IRA while working, you’d get a $150 tax break, but you’d pay $220 in tax on that contribution when you withdraw it after retirement. With a Roth IRA, the scenario plays out in an opposite manner. You won’t get to save the $150 in taxes on your contribution, but you also won’t pay the $220 in tax on your withdrawal.
Another scenario in which a Roth IRA is generally preferred over a traditional IRA is if you are a younger investor. If you start while you are young, by the time you retire, the earnings in your Roth are likely to far exceed the amount of your contributions. Although you will have missed out on the tax deduction you would have received by contributing to a traditional IRA, the tax-free treatment of your earnings should outweigh that benefit because your earnings will be a much larger slice of your retirement pie.
Other scenarios also favor a Roth IRA over a traditional IRA. For example, if your retirement will already be funded by other sources, you might prefer a Roth because there are no mandatory distribution requirements and you can continue to contribute indefinitely, unlike with a traditional IRA.
|IRA vs. Roth IRA Taxation on $100,000|
|Income Before Retirement||Annual Retirement Distributions||Tax Bracket Before Retirement||Tax Bracket in Retirement||Roth IRA Taxation||Traditional IRA Taxation|
|$100,000||$10,000||22%||15%||No deduction on contribution (no $2,200 deduction); no taxation of distribution (no $1,500 annual tax in retirement)||$2,200 deduction at time of contribution; $1,500 tax on each retirement distribution|
The top scenario in which you should choose a traditional IRA over a Roth IRA is if you anticipate being in a lower tax bracket in retirement than you are while you are working. In this scenario, you’ll benefit from getting a tax deduction while you’re in a high-income tax bracket, and you’ll only pay a low-income tax rate on your withdrawals in retirement.
If your income is too high to contribute to a Roth IRA, then a traditional IRA is obviously the only choice.
Most banks and financial services companies that offer investment options also offer both Roth and traditional IRAs. All Roth IRAs carry the same IRS requirements, so choosing a specific provider won’t be a work-around to contribution or distribution rules. But different firms might have different fees, investment options and other characteristics, so you’ll have to shop around to find the best Roth IRAs.
To make the research process easier, GOBankingRates has compiled a list of the best Roth IRAs accounts.
Free or low-fee Roth IRAs can be found at low-cost or online brokers such as Vanguard, Charles Schwab or Fidelity. Full-service firms such as UBS also offer Roth IRAs, but you might have to pay an annual custodial fee on top of any commissions or other service fees.
Just as with Roth IRAs, you can find traditional IRAs at any major online or brick-and-mortar financial services firm. Individual firms can’t change the IRS rules for traditional IRAs, but they can offer different investments or a different pricing structure.
The best traditional IRA for you will be the one that offers the most service for the lowest total fee. For example, if you need a full-service broker to help guide you with your investments, a traditional IRA with a major wirehouse such as Merrill Lynch might be your best option, even if it charges higher fees. If you are a frequent trader and need the lowest possible commissions to keep down your investment costs, an online broker like TD Ameritrade might be a better option.
Considering that saving is a struggle for many Americans, you’re ahead of the game if you can contribute to either a traditional or a Roth IRA. Choosing between the two is part art and part science. Because no one can guarantee what future tax rates will be, many investors use a combination of both types of accounts to benefit from current tax deductions and from future tax-free withdrawals. You might want to consider sitting down with a financial advisor or CPA to construct potential retirement scenarios and see which type of account might be preferable for you.
John Csiszar worked for 19 years as a financial advisor both with a major wirehouse and at his own registered investment advisory firm. Along the way, he earned his Series 7, 63, and 65 licenses, in addition to a California Insurance License and a Certified Financial Planner designation.
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