Individual retirement accounts (IRAs) are a popular retirement savings vehicle that can help you save for retirement and provide a steady stream of income during your retirement years. There are two main types of IRAs: traditional IRAs and Roth IRAs. In this article, we will explore the differences between traditional and Roth IRAs, including how they work, their tax benefits, and their contribution and distribution rules.
Traditional IRA vs. Roth IRA – How They Work
Traditional IRA
A traditional IRA is a retirement savings account that allows you to make tax-deductible contributions. Your contributions grow tax-deferred until you withdraw them in retirement. Once you reach age 72 (70 1/2 if you turned 70 1/2 before January 1, 2020), you must begin taking required minimum distributions (RMDs) from your traditional IRA.
Roth IRA
A Roth IRA is a retirement savings account that allows you to make after-tax contributions. Your contributions grow tax-free, and you can withdraw your money tax-free in retirement. Roth IRAs do not have RMDs, meaning you can leave your money in the account for as long as you like.
Eligibility
Both traditional and Roth IRAs have eligibility requirements. To contribute to a traditional IRA, you must be under age 72 (70 1/2 if you turned 70 1/2 before January 1, 2020) and have earned income. To contribute to a Roth IRA, you must have earned income and your income must fall below certain limits.
Contribution Limits
Both traditional and Roth IRAs have contribution limits. For 2023, the contribution limit for both traditional and Roth IRAs is $6,500, or $7,500 if you are age 50 or older. These limits are subject to annual cost-of-living adjustments.
Investment Options
Both traditional and Roth IRAs offer a wide range of investment options, including stocks, bonds, mutual funds, and exchange-traded funds. The investment options available may vary depending on the financial institution that holds your IRA.
Traditional IRA vs. Roth IRA – Tax Benefits
Tax Deductibility
One of the main tax benefits of a traditional IRA is that your contributions are tax-deductible, as long as you meet the eligibility requirements. This means that your contributions reduce your taxable income in the year that you make them. However, when you withdraw your money in retirement, you will owe taxes on your withdrawals at your ordinary income tax rate.
Tax-Free Withdrawals
One of the main tax benefits of a Roth IRA is that your withdrawals are tax-free in retirement. This means that you can withdraw your contributions and earnings without owing any taxes. This can be especially beneficial if you expect to be in a higher tax bracket in retirement.
No RMDs
Another tax benefit of a Roth IRA is that there are no RMDs. This means that you can leave your money in the account for as long as you like, and you can continue to benefit from tax-free growth.
Tax Treatment of Earnings
The tax treatment of earnings is different for traditional and Roth IRAs. In a traditional IRA, your earnings grow tax-deferred, meaning that you do not pay taxes on your earnings until you withdraw them in retirement. In a Roth IRA, your earnings grow tax-free, meaning that you do not pay taxes on your withdrawals because you already paid taxes up front on the money you invested in the Roth IRA.
Conversion Options
If you have a traditional IRA, you may be able to convert it to a Roth IRA. This can be a good option if you expect to be in a higher tax bracket in the future. However, you will owe taxes on the amount you convert, as the money in a traditional IRA has not yet been taxed. Additionally, once you convert to a Roth IRA, you cannot undo the conversion.
Traditional IRA vs. Roth IRA – Contribution and Distribution Rules
Contribution Rules
Both traditional and Roth IRAs have different contribution rules. With a traditional IRA, you must stop making contributions once you reach age 72 (70 1/2 if you turned 70 1/2 before January 1, 2020), while with a Roth IRA, you can continue to make contributions as long as you have earned income.
Early Withdrawal Penalties
If you withdraw money from a traditional IRA before age 59 1/2, you may be subject to a 10% early withdrawal penalty. With a Roth IRA, you can withdraw your contributions at any time without penalty, but you may be subject to a penalty on earnings if you withdraw them before age 59 1/2.
Required Minimum Distributions (RMDs)
As mentioned earlier, traditional IRAs have RMDs, which require you to start taking distributions from your account once you reach age 72 (70 1/2 if you turned 70 1/2 before January 1, 2020). With a Roth IRA, there are no RMDs, meaning that you can leave your money in the account without withdrawing at regular intervals.
Traditional and Roth IRAs are both popular retirement savings vehicles, and each has its own unique advantages and disadvantages. Traditional IRAs offer tax-deductible contributions, tax-deferred growth, and RMDs, while Roth IRAs offer tax-free withdrawals, no RMDs, and tax-free growth. When choosing between the two, it is important to consider your current tax situation, your expected tax situation in retirement, and your overall retirement goals. Ultimately, the right choice will depend on your individual circumstances and financial goals.
Resource Links
Schwab: Roth IRA vs. Traditional IRA
Internal Revenue Service: Traditional and Roth IRAs
Internal Revenue Service: IRA Contribution Limits