Note: This article is part of our Basic Banking series, designed to provide new savers with the key skills to save smarter.
Individual retirement accounts (IRAs) help you build a secure financial future, with some tax benefits thrown in. Whether you should open a Roth vs. Traditional IRA will depend on a few different things, including how much money you make and whether you'd like to enjoy a tax break on your savings now or in retirement.
Whether you’re using an IRA to grow your savings on top of what you’re contributing to your 401(k) or as your main source of retirement savings, it pays to make the right choice. We've broken down the differences between Roth vs. traditional IRAs to make the decision-making process easier.
Roth vs. Traditional IRA at a glance
Roth and Traditional IRAs don't get the same tax treatment by the IRS. With Traditional IRAs, contributions may be 100% deductible at tax time. Taking deductions for Traditional IRA contributions could shrink your tax bill or position you to get a refund. The trade-off is that you'll have to pay tax on the earnings in your Traditional IRA once you start withdrawing that money in retirement. Withdrawals made beginning at age 59 ½ are taxed at your regular income tax rate.
Roth IRAs, on the other hand, are funded with after-tax dollars. This means you don't get a deduction for contributions. But here's what you do get: 100% tax-free withdrawals in retirement. That's appealing if you're expecting to be in a higher tax bracket when you retire than you are now. Taking money from your Roth IRA wouldn't increase your tax liability since qualified withdrawals are tax-free.
Roth IRAs and Traditional IRAs both offer a way to save for retirement on a tax-advantaged basis. For 2020, you can contribute up to $6,000 to either account, plus an additional $1,000 in catch-up contributions if you're age 50 or older.
So, the key question to ask is: Would it be better to get a tax break up front or in retirement? The challenge is predicting what your tax situation might look like decades down the road.
|Roth IRA||Traditional IRA|
|Age Requirement||No restrictions on contributing at any age as long as income criteria is met.||You can contribute up to age 72. Beyond that age, you must take required minimum distributions (RMDs).|
|Annual Contribution Limit||$6,000; you can contribute up to $7,000 if you’re age 50 or older.||$6,000; you can contribute $7,000 if you’re age 50 or older.|
|Withdrawal Rules||If you’re 59 or under, you can withdraw your contributions at any time without worrying about taxes or penalties. However, if you withdraw your earnings, you could face taxes and/or penalties.||You’ll face early withdrawal penalty and taxes for early withdrawals (before age 59 ½), unless you meet certain exemptions.|
|Early Withdrawal Penalties||If 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 Advantages||Contributions 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 Limitations||2020 income limits vary based on tax filing status.||None.|
Roth vs. traditional IRA contribution rules
Generally, as long as you have taxable compensation for the year — either from working a traditional job or being self-employed — you’re IRA eligible. The exception is if you’re married and your spouse works but you don't. In that case, your spouse could contribute to a spousal IRA on your behalf.
If you’re trying to determine whether a Roth IRA or a Traditional IRA makes more sense, it helps to start with the eligibility guidelines. Specifically, your income determines:
- Whether you can make contributions to a Roth IRA
- How much of your deductions to a traditional IRA are tax-deductible
It's a simple two-step test that can pin down which type of IRA will work for you.
Who can make Roth IRA contributions?
For the 2020 tax season, you can make a full contribution to a Roth IRA if you’re a single filer with a modified adjusted gross income of less than $124,000. Reduced contributions are allowed if you earn between $124,000 and $139,000. Your ability to contribute is completely phased out once your income passes $139,000.
For married couples filing a joint return, full contributions are allowed when your combined income is less than $196,000. Partial contributions are allowed for couples with a combined income between $196,000 and $206,000. Once you pass the $206,000 mark, no Roth IRA contributions are allowed.
A work-around to income limits: Backdoor Roth IRAs
However, you may be able to get around the Roth IRA income limitations by using a backdoor Roth IRA. A backdoor Roth is when you contribute funds in a traditional IRA and then convert the funds into a Roth IRA. In doing this, though, you will have to pay some taxes upfront though.
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.
Who can deduct Traditional IRA contributions?
If you’re not income-eligible for a Roth IRA, you could still contribute to a Traditional IRA. Whether you can deduct your full contributions comes down to three things:
- Your income
- Your filing status
- Whether you're covered by a retirement plan at work
For the 2020 tax filing season, you can deduct your full traditional IRA if you're covered by a plan at work, are a single filer and made $65,000 or less for the year. Full deductions are allowed for married couples filing jointly who earned $104,000 or less.
If you don’t have access to a retirement plan at work and you file single, you can take the full deduction, regardless of how much money you make. Married couples filing jointly can take the full deduction if their combined income is $196,000 or less.
Similarly to the income thresholds for Roth IRA phaseout, the income thresholds for deducting full traditional IRA contributions are increased annually for inflation.
Age requirements for Roth vs. traditional IRAs
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. That means you can continue saving in a Roth IRA indefinitely, until you actually need to tap into that money. If you pass away, however, your beneficiary would have to withdraw funds from the account.
A Traditional IRA, on the other hand, has an age restriction that will not allow any more contributions after age 72. In fact, you're required to start taking money out of your account once you reach age 72.
Roth vs. Traditional IRA withdrawal 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 original contributions without penalty before age 59 ½.
Here are some of the exceptions to withdrawing IRA funds penalty-free:
- First-time homebuyers, who can withdraw up to $10,000 without penalty
- Military reservists called to active duty
- Rollovers from one eligible plan to another within 60 days
- Funding for qualified higher education expenses
It's helpful to consult with a tax professional to discuss any potential tax consequences if you're considering an early withdrawal. For example, withdrawing earnings from a Roth IRA before age 59 ½ may trigger a tax penalty.
Remember, you’re required to begin taking minimum distributions from your traditional IRA at age 72. The amount you're required to withdraw is based on your account balance and life expectancy. And according to California-based certified financial planner David Rae, this distribution difference can make a Roth IRA more attractive for some investors — with a Roth IRA, you don’t have to start taking distributions at a certain age if you don’t want to.
Who would benefit from a Roth IRA?
When trying to decide whether a Roth vs. Traditional IRA is better for you, it’s important to consider both current and future factors.
“It depends if you want the bird in the hand right now or when you’re a bit older,” said Rae. “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 noted that 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. According to Rae, he considers this 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 IRA: “It’s something we consider on a case-by-case basis.”
How to invest in an IRA
You can open a Roth or traditional 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 your employer offers a matching contribution.
When you’re 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.
Investment options for Roth vs. traditional IRAs
The options for investments for your IRA or Roth IRA are more or less the same, according to Rae.
Conservative investments: 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. 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.
Moderate investments: 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 to a more conservative or aggressive approach. “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.”
- Aggressive investments: 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,” said Rae.