Many of us ignore our retirement accounts for much of our working lives. We look at a pay stub and have a vague sense of the “minuses:” Social Security, insurance, taxes. But the traditional Individual Retirement Account (IRA) is one of the most powerful retirement savings tools available, so it warrants attention.
Its variant, the Roth IRA, also offers dynamic savings and investment options. Whatever works best for you depends on your current and future circumstances and financial goals.
These two types of IRA accounts differ in their tax treatment, withdrawal rules, and eligibility requirements. Being intentional about your choice is important to help ensure long-term financial success.
Key Differences Between Traditional and Roth IRAs
If you’re wondering which IRA is better, the answer depends on you. The best way to choose is to understand the key differences, check your eligibility, and calculate which can help you save more in the long run.
Tax Treatment
The most significant difference between a traditional IRA and a Roth IRA is the way taxes are paid on the money. Contributions to traditional IRAs are made with pre-tax dollars, and growth is tax-deferred. That means you don’t pay taxes on any of these funds, whether contributions or investment returns, until you withdraw them. Then you pay taxes based on your income and tax bracket at the time.
With a Roth IRA, you pay taxes upfront on your contributions based on your current income level and tax bracket. Since the IRS has already received its cut, the growth is tax-free, and withdrawals in retirement are almost always tax-free.
Traditional IRA benefits include a potentially lower tax bill today, while Roth IRA benefits include a potentially lower tax bill in retirement.
Income Limits and Contribution Rules
When you ask yourself, “Should I get a Roth or traditional IRA?” the first thing you need to consider is which one or ones you qualify for. Different eligibility requirements may impact what type of IRA you should open. The key factor is income level.
Generally, anyone with earned income can contribute to a traditional IRA. In contrast, you can only contribute to a Roth IRA if your modified adjusted gross income falls below limits set by the IRS. These limits may change from year to year.
Note that the amount you can legally contribute annually to any IRA or a combination of the two is also limited by the IRS. In addition, for a traditional IRA, your tax deduction may be further limited if you (or your spouse, if you are married) are covered by a retirement plan at work and your income exceeds certain levels.
Withdrawal Rules and Required Minimum Distributions (RMDs)
Required minimum distributions (RMDs) are minimum amounts you must withdraw each year from your IRA account. Roth IRAs do not have RMDs until after the account owner’s death, when any beneficiaries are subject to IRS RMD rules.
For traditional IRAs, RMDs must begin on April 1 of the year following the calendar year in which you reach age 73. The IRS sets a minimum amount you must withdraw each year or owe penalty taxes.
How to Choose an IRA That’s Right for You
Whether you go with traditional versus a Roth IRA is a matter of weighing the differences against your life. What is your current income? What is your current tax bracket and your future expectations? What are your retirement goals? Taking stock of your retirement plans can help you choose and avoid making some common mistakes.
Since the most significant difference between the two types of IRAs is the tax treatment, the first thing to consider is whether you believe you will pay higher taxes on the money if it is taxed now or after you retire. Clearly, you want to limit your tax liability as much as possible. So, the simplest answer to “Which IRA is best for me?” is that a Roth IRA may be better if you are in a lower tax bracket now but expect to be in a higher tax bracket when you retire. A traditional IRA may be better if you could use an immediate tax break and wish to be in a lower tax bracket when you retire.
However, everyone’s situation is unique, and other factors could influence which account is right for you. That’s why it’s essential to estimate how much your account will likely grow under both scenarios. (Don’t forget to consider how much more you can invest if you aren’t paying current taxes on the money.)
Converting a Traditional IRA to a Roth IRA
If you select a traditional IRA, you are not necessarily tied down to this decision. Converting your tax-deferred retirement plan to a Roth IRA can provide substantial benefits, depending on your circumstances. A Roth IRA conversion is worth considering if:
- You realize you may be in a higher tax bracket than you previously expected in retirement
- Your portfolio lacks tax diversification
- Your annual earnings disqualify you from contributing to a Roth IRA (income is not a criteria for conversion)
- You would like to avoid RMDs and leave more money to your heirs
Conversion does have tax consequences. Based on your current marginal tax bracket, you will owe immediate taxes on the amount you convert. There are other potential restrictions and financial ramifications, so it’s important to talk to a financial advisor before undertaking this potentially beneficial strategy.
Seek Advice When Choosing Between Roth vs. Traditional IRAs
Your choice of IRA account can substantially impact your financial plan, so it’s a good idea to seek financial advice before you make a final decision. Your financial advisor can provide up-to-date information on IRS rules that affect these accounts and help you understand how each type of account fits into your overall long-term financial plan and how it will impact your current income.
To be custom-matched with an advisor you can trust to support your goals with customized planning, explore Carson’s advisor matching program today.
Michael Gruidel is a non-producing registered rep of Cetera Advisor Networks LLC. Cetera Advisor Networks LLC is under separate ownership from any other named entity.
Some IRA’s have contribution limitations and tax consequences for early withdrawals. For complete details, consult your tax advisor or attorney
Distributions from traditional IRAs and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59 ½, may be subject to an additional 10% IRS tax penalty.
Converting from a traditional IRA to a Roth IRA is a taxable event. A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.
If you are purchasing an annuity to fund any tax-qualified retirement plan (IRA), you should be aware that this tax-deferral feature is available with any investment vehicle and is not unique to an annuity. Carefully consider the features and benefits of the annuity before making the decision to purchase.
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