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Understanding the Difference Between Roth vs Traditional IRA

Written by Kayla Sloan

We all know that saving for retirement is one of the most important steps to create a secure financial future. But, when you begin looking at the different options, including Roth IRAs and traditional IRAs, you may find yourself feeling overwhelmed.

It can be difficult to decide between a Roth or traditional IRA if you aren’t familiar with how they work now and when you retire.

We’re going to break down exactly what the differences are between Roth vs traditional IRAs so you can pick whichever one is better for your financial situation.

The differences between a Roth IRA vs a traditional IRA

Roth IRATraditional IRA
Age RequirementNo restrictions on contributing at any age as long as income criteria is met.You can contribute up to age 70 ½. From that point, you must take a required minimum distribution.
Annual Contribution Limit$5,500 - You can contribute up to $6,500 if you’re age 50 or older. $5,500 - You can contribute $6,500 if you’re age 50 or older.
Withdrawal RulesAges 59 and under: You can withdraw your contributions at any time without worrying about taxes or penalties. But if you withdraw your earnings, you will face taxes and penalties. You’ll face early withdrawal penalty and taxes for early withdrawals (before age 59 ½), unless you meet certain exemptions.
Early Withdrawal PenaltiesIf you are under age 59 ½, you may have to pay an additional 10% for early withdrawals if you withdraw more than you contributed or unless you qualify for an exception.If you are under age 59 ½, you may have to pay an additional 10% for early withdrawals, unless you qualify for an exception.
Tax AdvantagesContributions aren’t tax deductible. That means you pay taxes on the funds you contribute..Contributions are tax deductible, meaning you can contribute funds without paying taxes on them right away.
Income LimitationsThe 2018 income limit varies based on tax filing status..None.

Roth IRAs and traditional IRAs are both retirement savings accounts that you can use to save and invest for your future retirement. While both can be good choices, there are a few key differences that may make one option better than the other for your particular situation.

Here are the main differences between a Roth IRA vs. a traditional IRA.

Age requirements

A Roth IRA has no age restrictions for new contributions to the account. You can contribute at any age, as long as you meet the other requirements on the account, such as being below the income limits.

A traditional IRA has an age restriction that will not allow any more contributions after age 70 ½.

Contribution limits

Both accounts have the same contribution limit. For 2018, the limit is the lesser of $5,500 or the total of your taxable income for the year. However, if you are age 50 and over, you can contribute an extra $1,000 as a catch-up contribution. This means you can contribute up to $6,500.

Distribution rules

With both types of accounts, you can withdraw funds at any time. However, if you are under age 59 ½, a withdrawal may be subject to a 10% penalty tax, unless you qualify for an exception. Roth IRAs allow you to withdraw your contributions without penalty before age 59 ½, as long as you don’t withdraw the earnings.

Some of the exceptions for early withdrawals without penalty are:
  • First-time homebuyers can withdraw up to $10,000 without penalty
  • Withdrawals for military reservists called to active duty
  • Rollovers from one eligible plan to another within 60 days
  • Qualified higher education expenses

The difference between a Roth IRA and a traditional IRA when it comes to distributions is that you are required to take distributions at age 70 ½ from a traditional IRA. A Roth IRA does not require distributions to be taken at any specific age. However, after the death of the owner, distributions on a Roth IRA are required.

David Rae, a certified financial planner with Financial Planner LA, says this distribution difference can make a Roth IRA more attractive for some investors.

“A Roth IRA gives you more control of your money if you don’t want to begin using your money at age 70,” he said. “With a traditional IRA, you have to start taking some of your money out after age 70 and ½.”

Tax advantages

Tax advantages may be the biggest difference between a Roth IRA vs. a traditional IRA, according to Rae.

When you contribute to a traditional IRA, you are able to deduct your contributions from your taxable income in the year in which you contributed. However, when you withdraw funds during retirement, you will have to pay taxes at that time. Your withdrawals will be taxed at your current tax bracket accordingly.

On the flip side, with a Roth IRA, you do not receive a tax deduction for contributions. But, when you withdraw funds, you will not have to pay taxes on those funds. Also, you can withdraw funds any time without penalty so long as you do not withdraw more than the original amount you contributed.

Income limitations

A traditional IRA has no income limit, however with a Roth IRA, you may not be able to contribute the full $5,500 if you are a high earner.

The 2018 adjusted gross income (AGI) limit for Roth IRA contributions is $189,000 for married, joint tax filers. If you earn less than this, you can contribute the full $5,500. If your AGI is between $189,000 and $199,000, you can contribute a reduced amount, and if your AGI is $199,000 or over, you are not eligible to contribute to a Roth IRA.

The limits are lower for those who are married filing separately, and those who file as single or head of household.

Helen Ngo, CEO of Capital Benchmark Partners, says there may be a way around the Roth IRA income limitations by using a “backdoor Roth.”

A backdoor Roth is when you contribute funds in a traditional IRA and then convert the funds into a Roth IRA. She cautions that by doing this, you will have to pay some taxes upfront.

Because the traditional IRA contribution is tax deductible, but Roth IRA contributions are not, you will have to pay back the tax deduction if you convert your funds. You may also have to pay capital gains tax if you convert funds from your IRA that have earned investment gains.

These extra steps may pay off for high-income earners that may not otherwise be able to contribute to a Roth IRA and allow their money to grow tax-free.

Early withdrawal penalties

As mentioned earlier, if you withdraw funds from a Roth IRA or a traditional IRA before age 59 ½, you may have to pay a penalty. There are a few exceptions to this rule, including being able to withdraw funds for higher education expenses and first-time homebuyers. Consult with a tax adviser or financial planner before making a withdrawal.

For Roth IRAs, contributions may be withdrawn without penalty before age 59 ½. However, if you withdraw more than you contributed to the Roth IRA (i.e.: your earnings), the earnings will be subject to the tax penalty.

Who would benefit from a Roth IRA?

When trying to decide which option is better, a Roth IRA vs. a traditional IRA, it’s important to consider both current factors and future factors.

“It depends if you want the bird in the hand right now or when you’re a bit older,” Rae said. “I find that a lot of people go for the tax deduction of a traditional IRA. For younger people, that may be their motivation to save for retirement.”

However, Rae said he encourages young people to contribute to a Roth IRA rather than a traditional IRA. This is because the funds have longer to grow tax-free. Plus, young people with a lower income will not see as much benefit from a tax deduction on contributions if they are already in a low tax bracket.

Who would benefit from a traditional IRA?

Traditional IRAs can be a good option to help lower taxable income. Rae says this is especially important if you are just barely above the AGI limit in a higher tax bracket.

“Maybe you got an extra bonus at work and it pushed you into a higher tax bracket,” he said. “Contributing to a traditional IRA may give you enough of a tax deduction to offset that.”

Rae also says that for higher income individuals that are above the Roth IRA income limits, a traditional IRA is the way to go. But he, too, will sometimes suggest using a backdoor Roth.

“It’s something we consider on a case-by-case basis,” he said.

Investing vehicles for your IRA

You can open an IRA at many financial institutions, such as brokerage firms or banks. If your employer offers a 401(k) or Roth 401(k), definitely explore those options first, especially if they offer a matching contribution.

When you are ready to fund your IRA, be sure you understand your financial goals, your tolerance for risk and how long you have to save. These are the three key questions any investor should ask before they choose where to put their money.

If you are older, with less time to bounce back from a market setback, you might be more conservative with your investments, shying away from the stock market and instead choosing safer, low-yield investments like bonds or CDs. However, if you are younger, have a healthy risk tolerance and want to be a bit more aggressive, you might want to opt for a majority-stock portfolio.

These days, it’s easy to diversify your portfolio by choosing ETFs or index funds, which allow you to spread your savings across many different investments. Diversity is important. If you’re not properly diversified, you’re leaving yourself vulnerable to the fate of just a few investments. If one of them begins to tank, it could drag your whole retirement fund down with it.

The options for investments for your IRA or Roth IRA are the same, according to Rae.

Some of the more conservative options for IRA investments include IRA savings accounts and IRA CDs. However, the interest rates on these types of investments are typically lower than what you might stand to gain by investing in mutual funds or stocks.

Rae says if you are looking for a conservative investment and decide to use an IRA CD, a longer-term CD will usually provide a higher interest rate.

“However, rates are creeping up, so you may not want to lock in those funds for too long,” Rae said. “We don’t know for sure, but we expect that as rates rise, the interest rates on savings and CDs will increase as well.”

If you do lock in a long-term IRA CD, you should be aware that withdrawing funds early may result in an early withdrawal penalty.

More moderate investments to consider with your retirement planning are target date funds. According to Rae, a target date fund can be a good option if you want to be a “hands-off” investor because it will automatically become more conservative as the target retirement date approaches.

Rae also said there are a few adjustments you can make with target date funds to cater toward a more conservative or more aggressive approach with your investments as well.

“If you want to be more conservative, pick a date that a little earlier than you actually want to use your funds,” he said. “Or, if you want to be a little more aggressive, use a target date fund that’s one increment after your projected retirement date.”

One of the most aggressive options that also comes with more risk is investing in individual stocks. While the return has historically been higher for stock investments, they also come with more risk.

According to Rae, a balance between some aggressive investments and some conservative investments is important and is something your investment adviser or CFP will help you establish for your individual situation.

The most important thing is that people start saving for retirement as early as possible.

“The earlier you start, the more time your money has to grow,” Rae said.

zz   |     |   Comment #1
If you or your spouse participate in a retirement plan at work and you make too much money, greater than $70,000 single or $191,000 if married ($116,000 if both have retirement plans), you can still fund a traditional IRA but you cannot deduct it. In this case, you absolutely should do the back door Roth IRA. Since in both cases it is not deductible, it makes sense to do the back door Roth to get all the advantages of the Roth since the only traditional IRA benefit has been eliminated. Open a nondeductible IRA on Jan1 and then convert that to a Roth IRA on Jan2. This way there will be no taxes to pay when you do the conversion.
zz   |     |   Comment #2
I've had friends who were not contributing to an IRA as they were trying to establish an "emergency" fund net egg first, which is prudent. I suggested contributing to a Roth IRA with that money instead. If an emergency occurred, they could simply withdraw the contributions from the Roth penalty and tax free. If an emergency never occurred, hey, that money is now being saved for retirement.

I know financial advisors cringe at this suggestion as they feel you should never withdraw from an IRA early but if the alternative is to not even open an IRA, I think they have to make an exception.

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