Roth vs Traditional IRA – which is the better choice?

The U.S. government provides tax-advantaged programs for individual retirement accounts (IRAs). There are two main options – A traditional IRA and a Roth IRA. There’s an ongoing debate on which one is better. The traditional IRA was established in 1974 and still presents an excellent choice for your retirement account. The younger, Roth IRA, was introduced in 1997 and offers an alternate way of managing your retirement funds. To decide which one is ideal for you, the best option would be to contact one of the best IRS tax relief companies. But if you would rather have all the information necessary to make the choice on your own, then this article is for you. We will detail both IRA options and provide you with a comparison between Roth vs Traditional IRA, as well as offer a few tips to make choosing the best option for you a bit easier.

The basis of Roth IRA and Traditional IRA

person considering Roth vs Traditional IRA
Contributing to an IRA is usually much safer than investing in the stock market.

To start with, you will need to know what each IRA offers. Knowing more about your options is one of the key steps to retirement planning, after all. There are a lot of similarities between the two accounts but there are some key differences as well. Most notably, one account allows you to owe money to the IRS now while the other allows you to owe them later. Furthermore, the accounts differ in eligibility standards, accessibility of funds, and how they deal with tax deductions. Let’s start with the newer option, the Roth IRA.

Roth IRA

First of all, to be eligible for a Roth IRA, you need to have a MAGI (Modified Adjusted Gross Income) that is lower than $144,000. Do note that if your MAGI is higher than $129,000, the contributions to the account will start to phase out. If you are filing jointly with your spouse, the MAGI range is $204,000 to $214,000.

There is no tax deduction when you make a contribution to this particular account, meaning that your AGI is not lowered for the tax year. While this may sound absolutely horrible, this is leveraged by the fact that there is no tax on withdrawing funds from Roth IRAs during retirement. You’ve paid all the tax bills upfront, after all, and you will not need to pay them again once you retire. This will protect your income from taxes when it needs the most protection. If you are looking to pay your taxes sooner rather than later, Roth IRA presents you with that option.

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Required minimum distributions

Another important aspect of Roth IRAs is the fact that they do not have any RMDs (Required Minimum Distributions). What this means is that there are no requirements to withdraw money at any point, something that many other IRAs enforce. Therefore, many people choose to use a Roth IRA to transfer their wealth to other beneficiaries. Roth IRA beneficiaries will not owe any income tax on withdrawals but they will be required to take the distributions or “roll” the account into their own IRA.

One of the key differences (more on them later) when comparing Roth vs Traditional IRA is the fact that you are able to withdraw sums that are equivalent to your contributions to Roth IRAs at any time, without any penalties and taxes whatsoever. Because you already paid the taxes when contributing to the IRA. Or, to be more precise, you did not lower your AGI by making these contributions, which amounts to the same thing. This allows you to cut your tax bills when you need them to be cut the most. Other IRAs simply do not have this option.

tax time sticker
You will pay taxes either way – the choice is between now and later.

A very important thing to note is that you are capable of owning and funding both a traditional and a Roth IRA. Of course, you need to be eligible for both of them and the total amount that you can deposit will not be any higher. You will still be limited by the overall IRA contribution limits.

Traditional IRA

A traditional IRA allows taxpayers to make contributions that lower their taxable income in the same year that they make them. This effectively lowers your AGI and may help you qualify for numerous tax deductions. A few examples of these deductions include the student loan interest deduction as well as the child tax credit. Furthermore, any withdrawals from the traditional IRA are taxed according to your income tax rate at the time of the withdrawal.

Lastly, withdrawing money from this account before the age of 59 and a half will incur an early withdrawal penalty of 10%. There are some situations in which this penalty will not apply, such as when paying for qualified higher education expenses, first-time homebuyer expenses, as well as some medical expenses. Do note that even if you do not pay the early withdrawal penalty, the withdrawal itself will be fully taxed. There are certain ways to boost your tax refund amount when withdrawing money from traditional IRAs but they are very specific and may require professional guidance. If you want to maximize your refund, it is always best to talk to a tax professional.

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The differences between Roth and Traditional IRA

two people considering Roth vs Traditional IRA
You will have to make RMDs after you reach 72 years of age.

No matter which IRA you choose, you can expect considerable tax benefits. The main difference lies in when those tax breaks happen. Traditional IRAs offer their benefits immediately while Roth IRAs offer the most benefits once you retire. Furthermore, traditional IRAs have RMDs while Roth IRAs do not. This is due to the fact that the withdrawals from the former are fully taxable. With traditional IRAs, even if you don’t need the money, you will have to withdraw a percentage of your funds at the age of 72.

Roth vs Traditional IRA – Comparison

The contribution limits are identical for both IRAs. You can contribute a total of $6,000 each year if you are 49 or younger, and $7,000 if you are age 50 or older. Neither account imposes an age limitation on contributions. Both accounts offer up to $10,000 in penalty-free withdrawals for first-time homebuyer expenses. Some tax breaks for homeowners may also depend on the source of the funding. Furthermore, both accounts are eligible for the “Saver’s Tax Credit”. And that is where the similarities end.

When it comes to income limits, traditional IRAs allow anyone that earns an income to contribute. Roth IRAs, on the other hand, have income limitations as to who can contribute. In 2022, these limitations are $144,000 for single filers and $214,000 for joint filers. However, traditional IRA tax deductibility has other restrictions such as participation in an employer plan. Comparing Roth vs Traditional IRA by income limitations can be quite difficult and may require professional assistance.

Roth IRAs do not have RMDs for the account owner but beneficiaries will be subject to the RMD rules. With traditional IRAs, distributions need to happen at age 72 for the account owner and beneficiaries are subject to RMD rules as well. Lastly, Roth IRAs allow for withdrawal of earnings, penalty-free, in certain cases.

Withdrawing your earnings

If you want to withdraw a sum that exceeds your contributions (earnings), it is ideal to have a Roth IRA. This is due to the fact that you can avoid paying heavy penalties for withdrawing earnings if you fall into any of the following categories and have a Roth IRA for at least five years:

  • Permanent disability
  • 59 and a half years old
  • Using the money for a first-time home purchase, with a lifetime limit of $10,000
a house
You can avoid the penalties if you are using the money to purchase a home for the first time.

It is also possible to avoid the 10% withdrawal penalty if your account is younger than five years. Here’s how:

  • Being 59 and a half years old
  • Withdrawing money due to financial hardship or a disability
  • Using the money for certain medical costs, qualifying education expenses, or a first-time home purchase

Do note that these rules apply only to earnings from your IRA. Regular withdrawals are still tax-free. While this may sound to be in favor of a Roth IRA, traditional IRAs offer similar benefits. If you happen to be within any of the above-mentioned categories, you can expect to be able to make penalty-free withdrawals from a traditional IRA as well.

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Roth vs Traditional IRA – Which one should you choose?

The choice between the two accounts mostly falls down to your “future income”. Basically, choose a Roth IRA if you predict that your retirement income bracket is going to be higher. Otherwise, a traditional IRA might be your best bet. This is due to the fact that you will be paying taxes for contributing to Roth IRA by your current income bracket. Whereas a traditional IRA will have you paying taxes for the income bracket upon withdrawal.

Now, you may think that there’s no way that your income is going to be higher when you retire. However, this is not always the case. While your gross income may be lower, your taxable income might not be. You may be collecting money from investments, social security benefits, freelance work, etc. They can easily push your income bracket into the next category. Furthermore, once you retire, you may lose access to certain tax credits and tax deductions. You may easily find yourself paying more taxes than when you were working full-time.

person doing calculations to choose between Roth vs Traditional IRA
You will need to carefully consider your future income bracket.

If you do not want to guess what your income bracket will be, and are willing to receive fewer benefits, you can opt to contribute to both Roth and traditional IRA. There are certain requirements, of course, most notably the yearly contribution limit.

Frequently asked questions about individual retirement accounts

Should I max out an IRA?

It is generally advisable to max out your IRA. The contributions come with significant tax breaks. Most of the time, these tax breaks will provide more value than stocks, funds, and shares. When you think about this for a bit, if contributing to an IRA was not such a good idea, why would there be a limitation to contributions? Or why would that limitation not be much higher than it currently is? Bottom line is, max out your IRA if you can. Chances are that those contributions will be one of the smartest financial decisions you make.

Can I contribute to an IRA if I already have a retirement plan from my employer?

Yes, you can. However, the IRA contribution limits still apply. Furthermore, if you or your spouse are covered by a sponsored retirement plan and you happen to exceed a certain level of income, you might need to make some contributions without the full tax deduction.

person handing a document to another
You can still contribute to an IRA even if you have an employer retirement plan.

How big of a withdrawal do I need to make when I reach 70 1/2 years?

Once you reach the age limit for RMDs, the amount of money you will be required to withdraw each year is calculated by dividing the account balance (as of December 31 of the prior year) by the applicable distribution period (or life expectancy). You can use the tables found under IRS Publication 590b to calculate the exact number. If you happen to have a Roth IRA, you will not need to make RMDs.

Can I convert a traditional IRA to a Roth IRA?

Yes, under certain circumstances. First, you can do a “rollover”, where you receive a distribution from a traditional IRA and contribute it to a Roth IRA. The time limit between receiving the distribution and making the contribution is 60 days. You can also do a “trustee-to-trustee transfer” where you transfer the amount of money from your traditional IRA to a trustee of a Roth IRA but with another financial institution. Finally, you can also perform a “same trustee transfer”, where you simply transfer an amount from the traditional IRA to a Roth IRA.

However, any conversion from a traditional IRA to a Roth IRA will result in adequate taxation.

When comparing Roth vs Traditional IRA, the primary difference is when you pay your taxes. Roth IRAs allow you to pay taxes at your current income bracket while traditional IRAs will have you pay them at your future income bracket.

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