Roth IRA or Traditional IRA: Which Should You Choose?
Should you choose a Roth IRA or Traditional IRA? We break it down in this quick article so you can make the best choice for your retirement plan!
What do you want to do when you retire? Confront your enemies, wrestle alligators, open up a bar on a Costa Rican beach? Perhaps all three? Whatever it is, you’re going to need to save up a retirement fund — which means you need to know if you want to choose a Roth IRA or Traditional IRA. We’ve all run into these terms before, but it can get pretty confusing trying to decipher all the acronyms. But don’t worry — saving for retirement doesn’t need to be hard. By the end of this 7-minute guide, you’ll know everything you need about IRAs, Roth IRAs, and which one is right for you.
What is an IRA and Roth IRA?
IRA stands for individual retirement account. Like the name implies, they’re financial investment accounts that help you save for retirement through stocks, bonds, mutual funds, etc. IRAs are special because they have tax benefits that make saving easier — sort of like super-powered piggy banks with tax advantages. The two most popular kinds of IRA are the traditional IRA and the Roth IRA. Contrary to popular belief, the Roth IRA is just not a sexy reboot of the traditional. However, they have some significant similarities:
- Most brokerages (like TD Ameritrade, Fidelity, Schwab, etc.) offer some kind of IRA product.
- You have a contribution limit of $6,000 for all IRAs in your name ($7,000 if you’re over 50).
- Both traditional IRAs and Roth IRAs are meant to grow your investments tax-free.
Now let’s do a quick overview of the differences.
The Differences: Roth IRAs vs. Traditional IRAs
Traditional and Roth IRAs differ on four main aspects:
- Tax Benefits
- Income Limits
- Required Distributions
- Withdrawals Before Retirement
Let’s dive deeper into each one.
Tax Benefits for a Roth IRA vs. a Traditional IRA
With a traditional IRA, every investment you make — aka a contribution — is tax-deductible for the year you make them. This means that you can deduct some or all of the money you put towards a traditional IRA from your taxable income. The actual amount you deduct can depend on:
- If you have a pre-existing retirement plan at work (like a 401(k)).
- If you’re married. Or single. AF.
- Your income levels.
Lowering your taxable income for the year could mean you qualify for other tax incentives, like the Child Tax Credit, the Higher Education Tax Credit, and more. However, this does mean you’ll have to pay taxes on the withdrawals you make during retirement. On the other hand, Roth IRAs are not tax-deductible. As a result, any contributions you make to your Roth IRA account have no impact on your adjusted gross income for the year.
What’s the benefit, then?
Every time you make a withdrawal on that Costa Rican beach in your retirement, you won’t have to pay any taxes on it. (Post-retirement withdrawals are tax-free).
Income Limits on a Roth IRA vs. Traditional IRA
If you earn any amount of money, you can invest in a traditional IRA. Much like Beyonce, 2000s movie references, and making fun of people at the Met Gala, traditional IRAs are one of the few things we can all enjoy regardless of income level. If you want to contribute to a Roth IRA, things are a little bit more exclusive. If you’re single and your modified adjusted gross income (MAGI) is:
- Less than $125,000, you can contribute up to the limit.
- Between $125,000 and $140,000, you can contribute a reduced amount.
If your income is over $140,000 — you can’t sit with us. At the Roth IRA table. (Okay, that one was a stretch, but who can resist a good Mean Girls reference?). These figures change with your marital status, so try and determine where you fall. It also means that ‘Hey, you wanna qualify for a higher Roth IRA contribution limit?’ is an entirely valid way of asking someone out.
Required Distributions for a Roth IRA vs. Traditional IRA
Traditional IRAs comes with a condition: you must begin making withdrawals after you turn 72. These withdrawals are called required minimum distributions, or RMDs, and they can depend on your age, life expectancy, account size, and thoughts on MGK and Megan Fox’s relationship (okay, maybe not that last one). Roth IRAs are different. They don’t have any RMDs, so you can contribute to your account for as long as you’d like.
Withdrawals Before Retirement for Roth vs. Traditional IRAs
Some birthdays are more important than others — 16, 18, 21, 25, 59 and a half. Yeah, you heard us: 59 and a half. Withdrawing funds from a traditional IRA before you turn 59 and a half means paying taxes on your distribution AND a 10% penalty. The only way to avoid this is to use the money for home-buyer expenses (like a down payment on your first house) or higher education costs. Roth IRAs, however, allow you to withdraw as much as you have contributed. You can do this at any point (for any purpose), and you won’t pay taxes or a penalty. The only caveat is that unless you qualify for certain conditions, you cannot withdraw your earnings — only your contributions. (If you made $560 on an $8,000 investment, you can withdraw a maximum of $8,000). Let’s do a quick review of each super-powered piggy bank.
- Contribute from your pre-tax income, pay tax on withdrawals.
- Available to any person of any income.
- Requires minimum withdrawals at age 72.
- Tax-free withdrawals are only available after age 59 and a half.
- 10% early withdrawal penalty fee.
- Contribute from your post-tax income, withdraw money tax-free.
- Available to specific income brackets.
- Has no required minimum withdrawals.
- Allows you to withdraw contributions (not earnings) penalty-free at any time.
Traditional IRA vs. Roth IRA: Which One is Best For You?
Right now, you’re probably wondering: which one is right for me? A lot of it comes down to your expectations — do you expect to be in a higher or lower tax bracket after you retire?
- If you expect your income to be higher (and it might be, if you have other investments, passive income, Social Security, etc.), then go with a Roth IRA. You’ll get the advantage of paying lower tax rates now and enjoying tax-free withdrawals in retirement.
- If you expect your income to be lower, go with a traditional IRA. You’ll get tax benefits right now and pay lower taxes in the future
If you’re uncertain about your future income, Roth IRAs are still a better bet for most people. The withdrawal rules are more forgiving, so you can use your Roth IRA money as an emergency or rainy day fund. Unlike a Roth IRA, traditional IRAs provide you with immediate tax breaks every year. As a result, you might be tempted to spend instead of save. It’s wise to diversify your retirement investment accounts, whether it’s a Roth IRA, traditional IRA, 401(k), etc. Use them all! After all, your Costa Rican party shack/alligator wrestling ring isn’t going to build itself.
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Frequently Asked Questions
What is the downside of a Roth IRA?
A Roth IRA has certain limitations that might make it unattractive to some. For one, you have to be under a certain income level to make any kind of contribution. Roth IRA contributions aren’t tax-deductible either, so you might miss out on other tax incentives and benefits.
Is it wise to contribute to a traditional IRA and a Roth IRA?
It can be! By splitting your retirement savings between both investment accounts, you’re hedging against the uncertainty of your future tax rate. This way, you’ll get some tax benefits today and some in retirement. Even better, contribute to employer-matching accounts like your 401(k) as well.
Can you contribute to a traditional IRA and 401(k) at the same time?
Yes! Your workplace may already offer a Roth 401(k) plan, but creating a separate one doesn’t hurt either. If your employer matches your 401(k) investments to any degree, it’s best to maximize their contributions before you put money towards a separate Roth IRA.