Roth IRA vs. Traditional IRA: The Differences That Affect You

As you may know, the Roth IRA vs. traditional IRA debate has been going on for a while.

Let’s get this out of the way first: there’s still no easy answer to this question. Choosing between these two retirement accounts will depend on your specific situation.

In other words, you need to consider this decision carefully. Remember, there are some big differences between the traditional IRA and Roth IRA. In most cases, these differences will have a big impact on your savings.

Not sure how to choose the right IRA for you? Here are the key considerations you should keep in mind.

Contribution Limits

Do you have earned income? Are you 70 1/2 or younger? If the answer to both of these questions is yes, you can contribute to a traditional IRA.

Now, these contributions may or may not be tax-deductible. That depends on your income and whether you’re covered by an employee retirement plan. If you’re married, the same applies to your spouse.

Meanwhile, a Roth IRA doesn’t have an age restriction. Instead, it comes with an income-eligibility restriction. In 2019, contributing to a Roth IRA requires you to have a MAGI of less than $137,000.

If you’re filing jointly with your spouse, your MAGI must be less than $203,000. In this scenario, the phase-out range starts at $193,000. If you’re filing alone, the contribution limit gets phased out starting at $122,000.

Tax Breaks

Traditional and Roth IRAs both provide generous tax breaks. The only question is when you’re able to claim them.

A traditional IRA contribution is tax-deductible on state and federal tax returns. Withdrawals in retirement get taxed at standard income tax rates. Roth IRAs don’t provide tax breaks for contributions, but most withdrawals are tax-free.

If you’re in a lower tax bracket or believe you might be in a higher tax bracket during retirement, a Roth IRA should seem more attractive. Since you make those contributions with after-tax money, you can take advantage of TVM. Plus, tax-free growth is always welcome.

Of course, both types of IRAs will spare you from paying taxes on the growth of your contributed funds. The only rule is that these funds must remain in your account.

Withdrawal Rules

When it comes to withdrawals, traditional IRAs and Roth IRAs are quite different.

A traditional IRA requires you to start taking RMDs at age 70 1/2. By comparison, Roth IRAs don’t require you to withdraw any savings during your lifetime. The same applies to your heirs, though they may still owe estate taxes.

With enough other income, your Roth IRA can be a great wealth-transfer vehicle. Without mandatory withdrawals, you can have your Roth IRAs continue to grow tax-free. Plus, your beneficiaries won’t owe any income tax on withdrawals.

Finally, there’s the matter of qualified distributions. In this regard, traditional IRAs and Roth IRAs are fairly similar. They both allow you to begin taking these penalty-free distributions at age 59 1/2.

That said, there’s a slight wrinkle here. With a Roth IRA, you must make your first contribution at least five years before withdrawing anything. If you don’t meet this benchmark, you’ll incur a tax penalty.

Specific Benefits

When choosing the best IRA account for you, it’s worth considering the extra benefits.

For example, contributing to a traditional IRA lowers your taxable income. This lowers your adjusted gross income, which may help you qualify for more tax incentives. That includes the student loan interest deductions.

Traditional IRAs also allow you to withdraw up to $10,000 to pay for qualified expenses. Otherwise, you’d need to pay a 10% early-withdrawal penalty. This is only available for owners younger than 59 1/2.

Roth IRAs come with some useful benefits as well. For instance, you can withdraw your Roth contributions at any time. If you’re under 59 1/2, you may also be able to withdraw up to $10,000 of your earnings to pay for qualified expenses.

Also, you can invest your Roth IRA in anything you want. Index funds, individual stocks, and lifecycle funds are all viable possibilities. 

Future Tax Rates

Your income tax bracket should play a big role in deciding between these two IRA accounts. It all comes down to comparing the tax rates on your Roth IRA and your traditional IRA contributions.

What’s the difference? Simple: with Roth IRAs, you’re looking at the rates you’re paying today. With traditional IRAs, you’re looking at the rates you’ll be paying after you retire.

Now, this is easier said than done. Predicting what the state and federal tax rates will look like many years from now is not easy. That said, you can try to determine your situation by asking yourself a couple of basic questions.

For example, which federal tax bracket are you in right now? After you retire, do you expect to be in a lower or higher bracket? Do you expect your annual income to decrease or increase?

Most people believe that their gross income will decline in retirement. Though this may be true, taxable income is a different story.

Remember, you’ll still be collecting Social Security payments. If you’d like to do some freelance or consulting work, you’ll need to pay self-employment tax. You also lose some big tax credits and deductions once your kids grow up or expect to receive an inheritance.

Tax Credits and Deductions

Finally, a quick word on tax credits and tax deductions.

As you may know, both of these are a way to reduce your taxable income. A tax deduction will get subtracted from your gross income. In other words, the value of these deductions depends on your tax rate.

A tax credit always has the same value. This makes tax credits harder to obtain than tax deductions, but they’ll usually be worth it. If you can choose between a $5,000 credit or a $5,000 deduction, the former will be the better deal.

Roth IRA vs. Traditional IRA: Conclusion

As you can see, the choice between Roth IRA vs. traditional IRA is not an easy one.

If you’re uncertain about which way to go, consider hedging your bets. The easy way to do that is to keep some money in both types of IRA accounts. This diversifies your tax exposure and gives you leeway in managing withdrawals.

Need a professional opinion on your retirement situation? We may be able to help you out in that regard. Contact us right here — we’ll get back to you soon.