What Are the Differences Between a Traditional IRA and a Roth IRA?
An IRA, or individual retirement account, is a great vehicle for building wealth and saving for retirement. Although there are many different types of IRAs, each with their own pros, cons, and rules, the two most common IRAs are traditional IRAs and Roth IRAs.
Traditional IRAs were introduced in the Employee Retirement Income Security Act of 1974 (ERISA), which made it possible for individuals to save for retirement without having their contributions, or the growth of their accounts, immediately taxed. Roth IRAs were created by the Taxpayer Relief Act of 1997 to allow individuals to make qualified withdrawals from these accounts without being taxed.
When choosing any kind of bank or retirement account – checking and savings accounts, money market accounts, 401Ks, annuities, IRAs, etc. – the first step is to learn the basics about how each account functions, features and benefits, relevant laws, and tax implications. Even if you work with a financial professional who you completely trust, your own knowledge is critical to making sound financial decisions.
Here are some of the basic differences between a traditional IRA and a Roth IRA.
You can contribute to a traditional IRA until age 70 ½. There is no age limit for contributing to a Roth IRA.
Income-Based Contribution Restrictions
Both a traditional and Roth IRA require earned income (i.e. wages) to contribute.
Neither a traditional IRA contribution nor a Roth IRA contribution can exceed the earned income amount for the year, or the annual limits established by the IRS. These annual limits are $5,500 for people under age 50 and $6,500 for people age 50 and older. Limits could be reduced based on your total income.
Traditional IRA annual limits are not subject to reductions based on total income.
For a Roth IRA, the amount you can contribute can be reduced when your modified adjusted gross income reaches a certain range ($120,000-$135,000 if you’re single and $189-$199,000 for married couples filing jointly).
All or a portion of a traditional IRA contribution may be tax deductible, but this amount could be reduced or eliminated if you or your spouse participates in a qualified employer retirement plan, such as a 401K. The IRS has additional rules depending on your filing status. By lowering your taxable income, you could qualify for other tax incentives.
A Roth IRA contribution is not tax deductible.
Taxes and Penalties on Withdrawals
If you withdraw from a traditional IRA, the withdrawal amount and any contributions you previously deducted on your tax return will be considered taxable income. There’s also a 10 percent federal penalty tax on withdrawals of contributions and earnings when those withdrawals are taken before age 59 ½. However, withdrawals up to $10,000 to cover medical expenses, higher education and other qualified expenses and hardships may be exempt from the penalty.
You’ll never pay taxes on withdrawals of qualified Roth IRA contributions, regardless of age. Even withdrawals of capital gains are not taxed if you take them after age 59 ½. If you withdraw earnings prior to age 59 ½, you’ll have to pay the 10% federal penalty tax. However, if at least five years have passed since your first contribution, up to $10,000 can be withdrawn tax-free before age 59 ½ to pay for qualified first-time homebuyer expenses.
Required Minimum Distributions
For a traditional IRA, required minimum distributions must be taken when you reach age 70 ½. The first required minimum distribution must be taken by April 1 of the year after the year you reach age 70 ½. For example, if you turn 70 ½ this year, you’ll have to take the distribution by April 1, 2019. All subsequent distributions must be taken each year by December 31.
A Roth IRA must be open for five years for distributions to be tax-free. There are no required minimum distributions at any point with a Roth IRA. Many folks contribute or roll over to a Roth IRA if they expect to be in a higher tax bracket in the future or won’t ever need the money during their lifetime. Of course, it’s impossible to predict what state and federal tax rates will be 20 or more years into the future or if these rules will still be in place.
To be clear, part of our role as an accounting firm is to educate you about different options for retirement planning. This is a high-level overview of traditional IRAs vs. Roth IRAs, and there are a number of qualifiers and exceptions related to both types of accounts. We recommend speaking with a certified financial planner to determine which approach is best for you.