In my related blog post Why Should I Invest in an IRA?, I talk about some of the different types of IRAs and some reasons why you should get one. The Internal Revenue Service (IRS) created the Individual Retirement Account (IRA) to give taxpayers another way to save for retirement. Contributing to an IRA allows you to take advantage of market gains and possible tax benefits.
A question that often comes up when deciding to open an IRA for yourself is, “Which IRA is right for me – Traditional or Roth?” While both types have some similarities, they also differ in some important ways, including tax deduction, limitations, and accessibility of funds.
The traditional IRA was established in 1974 with the enactment of the Employee Retirement Income Security Act (ERISA). In a traditional IRA, you make contributions with money that may be tax-deductible. Any earnings can potentially grow tax-deferred until withdrawn in retirement. The traditional IRA is best suited for someone who expects to be in the same or lower tax bracket when taking retirement withdrawals.
The Roth IRA was introduced in 1997 and is named for its sponsor, Senator William Roth. In a Roth IRA, you make contributions with money that you have already paid taxes on. If certain conditions are met, your money may potentially grow tax-free, with tax-free withdrawals in retirement. Once your income reaches a certain level, you can’t contribute to a Roth IRA. The Roth IRA is best suited for someone who expects to be in a higher tax bracket when taking retirement withdrawals.
- Both traditional and Roth IRAs provide tax breaks, but the timing for claiming them is different.
- Contributions to traditional IRAs are tax-deductible on both federal and state tax returns for the year the contribution is made. This lowers your adjusted gross income (AGI), which may help you qualify for other tax incentives.
- Contributions to Roth IRAs aren’t tax-deductible in the year the contribution is made, but because of this, withdrawals in retirement are generally tax-free.
- Essentially, you pay the taxes now for Roth IRAs and later for traditional IRAs. Contributions for traditional IRAs are tax-deferred and contributions for Roth IRAs frow tax-free
- Anyone with earned income can contribute to a traditional IRA, up to the earned income amount, not to exceed the limit above.
- Contributions can be made to both traditional and Roth IRAs at any age.
- The maximum contribution per year, which is subject to adjustment, is $6,000 for 2021. It is $7,000 for those over the age of 50. This total applies to both types of IRAs combined. In other words, you cannot contribute $6,000 to a traditional IRA and $6,000 to a traditional IRA in the same year.
- Roth IRAs have income restrictions. For 2021, a single taxpayer must have a modified adjusted gross income (MAGI) of less than $140,000, with contributions being phased out starting at $124,000. Married couples must have a MAGI of less than $208,000, with contributions being phased out starting at $198,000.
- Taxes are paid when receiving distributions from contributions and earnings in retirement for traditional IRAs.
- No taxes are paid when receiving distributions from contributions and earnings in retirement for Roth IRAs, if the funds have been held for at least 5 years.
- With traditional IRAs, you must start taking required minimum distributions (RMDs) at age 72, whether or not you need the money. RMDs are taxable withdrawals of a percentage of your funds.
- With Roth IRAs, you are not required to withdraw money at any age, or even at all, if you so choose.
- If you withdraw money from a traditional IRA before age 59 ½, you will be required to pay taxes and a 10% early withdrawal penalty. In certain instances, you can avoid paying the penalty, like when paying for qualified first-time home-buyer or higher education expenses.
- You can withdraw money up to the amount of your contributions from a Roth IRA at any age without penalty. If you want to withdraw earnings from a Roth IRA before age 59 ½, your withdrawal may be taxable and/or subject to a penalty, depending on special rules, which can be found on the website for the IRS.
For the most up-to-date guidelines on traditional and Roth IRAs, visit the IRS website.
Check out my related investment post: What is Compounding and How Does it Affect My Investments?
The infographic below should help to summarize the main differences between traditional and Roth IRAs.
Disclaimer: This information is intended for educational purposes and is not tailored for the needs of any specific investor. It is important to conduct your own analysis and research before making any investment. It is recommended to independently research and verify or seek financial advice from a professional in connection with any information on this website before using it to make an investment decision or otherwise.