Traditional vs. Roth IRA
It’s long been a debate as to which Individual Retirement Plan (IRA) is better, especially for younger savers. Which should you choose? The Traditional IRA or the Roth IRA? There are many similarities between the two plans, but there are also some major differences that you should be aware of when choosing which is better for you. As long as you have earned income, you can contribute to either (or both) plans in any given year.
What is an IRA?
An IRA is a retirement account that can be opened and contributed to for any year in which you have earned income. Earned income can include your salary from a job, self-employment income, combat pay or a spouse’s income. Types of income that are not considered earned include pensions, annuities, interest & dividends and rental income.
IRAs allow you to save for retirement on a tax-deferred or tax-free basis. Since IRA funds are earmarked for retirement, there are generally penalties for withdrawing money too soon.
You can open your Individual Retirement Account at most financial institutions, including banks, brokers and mutual fund companies.
What is a Traditional IRA?
A traditional IRA is the most common choice. It is funded with pre-tax money and allows for a tax deduction in the year(s) in which it was contributed to. The IRS (Internal Revenue Service) sets a limit of just how much you can contribute to an Individual Retirement Account. For 2018, you can contribute up to $5,500 ($6,500 if you are at least age 50) or the amount of earned income for the year, whichever is less. There are no income restrictions for funding a traditional IRA. Note: As announced on November 1, 2018, the IRA contribution limits will increase to $6,000 ($7,000 for those age 50+) for 2019.
Your IRA contribution grows tax-deferred and is only taxed when you take distributions during retirement. Other than a few exceptions, you are subject to a 10% early withdrawal penalty if you take money out of your IRA before reaching age 59 ½. Traditional plans are also subject to the Required Minimum Distributions rules, or RMDs. Once you reach age 70 ½, you MUST start taking distributions, whether you want to or not. The amount is determined by the IRS using your IRA balance and your age. At this time, you are no longer allowed to make any contributions to your traditional IRA.
Distributions prior to age 59 ½ are subject to tax and a 10% early withdrawal penalty. There are exception to this penalty known as “hardship withdrawals”. You will not be penalized if you:
- withdraw money for higher education expenses (for yourself and immediate family),
- Make withdrawals for a first-time home purchase (up to $10,000 for your lifetime)
- Medical expenses
- Health insurance
- If you become disabled or pass away
Read the IRS Exception on Tax and Early Distributions for a full explanation of exceptions to the early withdrawal penalty.
What is a Roth IRA?
A Roth IRA, the lesser known option, differs from a traditional plan in several ways. n other words, you don’t get an upfront tax deduction. However, all qualified distributions from the plan are tax-free! For a distribution to be qualified you must satisfy two things: you must be age 59 ½ and the Roth account must have been open for at least five years.
While contribution limits are exactly the same as a traditional IRA, there are income limits which restrict high earners from directly contributing to a Roth IRA:
You may contribute fully to a Roth IRA if your earned income is less than $120,000 for 2018. Contributions are phased out up until $135,000. If you earned more than this amount, you cannot contribute to a Roth IRA. Note: These numbers increase to $122,000 and $137,000 for 2019.
Married filing jointly
You may contribute fully to a Roth IRA if your earned income is less than $189,000 for 2018. Contributions are phased out up until $199,000. If you earned more than this amount, you cannot contribute to a Roth IRA. Note: These numbers increase to $193,000 and $203,000 for 2019.
Another major difference is that Roth IRAs are not subject to RMDs. Since you have already paid taxes on your Roth contributions, the IRS does not require you to withdraw money from the plan at any time. You can then pass on the plan to your beneficiary fully intact. Also, there are no age restrictions for Roth contributions. As long as you have earned income, you can continue to contribute to a Roth IRA (even after you reach age 70 ½).
Roth plans also give you the ability to withdraw your contributions at any time and for any reason without taxes or penalties. If your distribution goes above the amount you’ve contributed to the plan to include earnings, these earnings will be subjected to penalties if it is an unqualified distribution.
As is the case with traditional IRAs, you are allowed to take certain hardship withdrawals at no additional penalties.
Traditional vs. Roth IRA – Summary
Each plan offers several benefits (along with some drawbacks). Depending on your specific situation, one might be better for you than the other. Here’s a final breakdown of each plan:
- Funded with pre-tax money – Receive an immediate tax break which lowers your taxes by the amount you contribute each year
- Taxes are differed – You don’t pay taxes until you start taking distributions during retirement
- Bump down a tax bracket – If you are on the cusp of a higher tax bracket, making a traditional contribution may keep you in the lower bracket
- No income restrictions – It doesn’t matter how much you earn, you can always contribute to a Traditional IRA (though high earners may not receive the tax deduction)
- RMD – You must start withdrawing from the plan once you reach age 70 ½
- Age Limit – Once you reach age 70 ½, you can no longer contribute
- Funded with after-tax money – You don’t receive an immediate tax break when you contribute
- Tax-free Distributions – All distributions are tax-free during retirement
- Income Restrictions – If you earn too much money, you cannot contribute to a Roth (though there is a work around called the “Backdoor Roth IRA”)
- No RMD – You are never forced to take money from your Roth plan
- No Age Limit – You can contribute to a Roth during any year you have earned income, regardless of your age
- Emergency Fund – Withdraw contributions at any time without penalty
There’s a lot to consider between a Traditional vs Roth IRA. As you can see, there are a number of differences (and similarities) between the two plans. Roth plans are generally suited towards younger individuals who benefit more from tax-free withdrawals. Traditional plans offer high earners a way to save on taxes right now. The only way you can go wrong is by not contributing to at least one of these plans.