Roth and traditional IRAs are beneficial retirement tools. However, there are limitations to both of these financial tools. This means that one or both of them may not be right for you. Read the guide below to help you choose between the two.
Traditional and Roth IRA Basics
Traditional IRAs allows you to make contributions on a pre-tax basis if your income is under a specific threshold. You don’t pay taxes until you withdraw from it. This is a great option for investors who know that they will be in a lower income bracket towards retirement. However, Roth IRAs contributions are made with after-tax dollars.
The main benefit of a Roth IRA is that you’re able to take your contributions and earnings tax-free after the age of 59 ½. The thing is that you have to have the account for at least five years or meet other requirements. In addition, you can withdraw from your contributions anytime. There’s no tax or penalty-fee either. The downside is that if you make an early withdrawal of your earnings, you’ll have to pay taxes and penalties on them. Overall, a Roth is a great option for investors who know they will be in a higher tax bracket towards retirement.
This type of retirement account does offer flexible spending for those in retirement. Moreover, you can withdraw your money without experiencing a tax bill increase. On top of that, you don’t have to take annual required minimum distributions (RMDs) when you turn 70 ½ years old.
Traditional and Roth IRA Basics – What’s the Same
- Fees – There are no maintenance or set-up fees. There are no transaction fees for most Fidelity mutual funds.
- Minimum investments – There are no minimums to open up a Fidelity IRA account.
- Contribution limits – $5,500 (age 49 and under) $6,500 for the age of 50 and older (as of 2019).
- Contribution deadline – Tuesday, April 17, 2018 (for the 2017 tax year).
Traditional and Roth IRA – Key Differences
What they have in common is that they both offer a powerful way to save for your retirement. It’s just the way they both go by doing – along with other terms – are totally different. You can always use roth vs. traditional IRA calculator to see the financial difference.
Anyone that earns income (under 70 ½ years of age) can contribute to an IRA. Your income and whether or not you and your spouse (if married of course) are covered by a retirement plan through your job determines whether or not your contribution is tax deductible.
Even though Roth IRA’s don’t have age restrictions, they so have income-eligibility restrictions. Tax filers that are single must have a modified gross income no less than $137,000 to contribute to a Roth IRA. A married couple’s modified AGI has to be less than $203,000 in 2019 in order to qualify for a Roth. Starting at $193,000, the contribution limits are phased out for married couples.
A major difference between a Roth and Traditional IRA is more than likely how and when you’ll receive a tax break.
- With having a traditional IRA, your contributions are tax deductible.
- A major advantage of a Roth IRA is that your withdrawals in retirement aren’t taxed.
Another way to say this is that with a traditional IRA, you only pay tax distributions in retirement or when you make withdrawals before the age requirement. A Roth IRA acts as the opposite. You pay your taxes upfront since the contributions aren’t tax deductible. Moreover, what you invest in a Roth grows tax-free, and it can any investment – dividend stocks, ETFs, gold investing or mutual funds. In the case of a traditional IRA, your investments grow tax-deferred.
Future Tax Rates
Determining which IRA track to take is contingent upon what you think your income tax bracket will be in the future in comparison to where it is now.
In essence, you want to examine if the tax rate you pay on your Roth IRA contributions today will be more or less than the rate you’d be paying on distributions from your Traditional IRA after retirement.
Furthermore, keep in mind that it’s not easy trying to determine federal and state tax rates will look like 10, 20, or 40 years from now. Due to the monumental low federal tax rates in accompany with a large US deficit, a lot of economists think that federal tax rates will increase in the future. This means that you’d be better off having a Roth IRA in the long-run. Only time will tell.
Above all, it’s important to ask yourself basic questions regarding your personal situation. What is your current federal tax income bracket? Do you believe you’ll be in a higher or lower income bracket after you retire? Will your annual income go up or down? Conventional wisdom states that gross income decreases towards retirement. The taxable income aspect of it doesn’t. Think about it this way. You’ll be collecting as well as owing taxes on social security payments.
You may be in the place now to begin withdrawing funds since you spent time putting money towards your IRA. In another case, you may be ready to buy a house or you need immediate funds because you lost your job. You may be wondering what the withdrawal restrictions are.
- In order to make withdrawals (for both Roth and traditional), you have to be at least 59.5 years of age.
- The IRS requires individuals that are 70.5 years of age to start making withdrawals from their retirement account.
- Regarding a Roth IRA, you aren’t required to withdraw from them. The money can stay in the account forever. You also have the power to transfer the money to a beneficiary before you die. In a way, this is a great avenue for wealth transfer. One thing to note is that beneficiaries of a Roth IRA don’t owe income tax on withdrawals. They can also prolong their distributions over a long period of time.
- If you are before the age of 59.5, the IRS charges a 10% federal penalty fee on early withdrawals from a Roth account. A good thing to note is that the penalty is taken solely on the earnings and not the principal. In addition, you can withdraw from it anytime tax-free. Above all, it’s important to keep the money in the account so you can see it grow.
- There’s a 10% federal penalty on the contributions and earnings on Traditional IRA’ when you withdraw early.
Required Minimum Distributions
Let’s say that you’re celebrating your 70th birthday. Six months after your birthday, you are subject to RMDs (Required Minimum Distributions) from your traditional IRA. Keep in mind that the IRS is eager to tax that money that’s been left alone for some time.
Withdrawing RMDs is not a bad thing when you are 70.5 years and living on your retirement savings.
If you know you already have a lot of wealth and don’t have to withdraw from your IRA, this would be less attractive. Not only you’re disturbing the growth that’s in your account, the IRS prevents you from contributing more. You can’t contribute additional funders after the 70.5 years of age.
For people who have long, healthy lives, the Roth rules and guidelines are less stringent. The IRS places no RMDs on a Roth (unless you inherit one as a beneficiary). You can view our Roth RMDs post for more information regarding this. For as long as you live, you have the power to keep your funds in an IRA to let it grow tax-free. Moreover, you have the power to contribute to your Roth IRA after 70.5 years of age. If you already have an abundance of cash in your account and decide not to touch your Roth account, you can pass it on as an inheritance to your children.
Roth vs Traditional IRAs: Extra Benefits & Considerations
It’s also a good thing to apply specific rules and benefits of both Traditional and Roth IRAs. Now here’s the breakdown.
During the contribution year, the IRS lowers your taxable income for Traditional IRAs. As a result, your adjusted gross income decreases. It positions you to qualify for other tax incentives you wouldn’t get otherwise. A child tax credit or student loan interest deductions are prime examples of this. Please be aware that if you or your spouse has an employer retirement plan such as 401(k), the power for you to deduct contributions may decrease or be eliminated altogether.
If you’re under the age of 59.5, you have the ability to withdraw up to $10,000 from your account without the IRS implementing a 10% early-withdrawal penalty as a result of buying your first home or paying for your kid’s college tuition.
Situations that revolve around developing a disability or unreimbursed medical expenses can also be exempt from the penalty. Nonetheless, you’ll still have to pay taxes on the distribution.
You can withdraw contributions of a Roth (not the earnings) penalty and tax-free anytime you need to. In additions, you don’t have to be 59 ½ years old.
If you’re under the age of 59.5, you have the power to withdraw up to $10,000 from your Roth earnings penalty-free to pay for first-time home-buyer expenses. You just have to at least five tax years since your initial contribution. You can invest in anything you want with a Roth IRA. Some examples are index funds, individual stocks, lifecycle funds, or other alternative investments.
When a Roth IRA May Make Sense?
A Roth makes sense if you're in a low-income tax bracket with a range of 20% or below. You can view our breakdown on income brackets if you don’t know where you currently stand. This is likely the scenario if you are still in the initial stage of your career, or you’ve had a career change that results in you being in a higher income bracket when you retire.
So why a Roth IRA? Your Roth IRA is not subject to income tax. So when you’re in your prime and start drawing income from your Roth IRA savings, you don’t have to come up with income taxes to the IRS when your tax rate increases.
When a Traditional IRA May Make Sense?
If you know that you are in a high-income tax bracket or you’re close to retirement age, a traditional IRA is the better option. Why may you ask? Having a Traditional IRA empowers you to get a tax deduction when it’ll benefit you the most.
People usually transition to a lower tax bracket after their 40s or mid-to-late 50s as a result of full or semi-retirement.
They do this while taking on jobs with low pay but have meaningful work or just needing to draw less income if expenses have gone down. As a result of withdrawals from an IRA being taxable as income taken after 59.5 years of age, choosing a traditional IRA can save you big-time since you’re withdrawing that money in a lower tax bracket.