While you might already be investing in your employer’s retirement plan (like a 401k or something), contributing to an Individual Retirement Account (IRA) will provide you another outlet to save for your retirement while also potentially helping you save money on taxes.
No matter where you are in life’s journey, even the smallest financial choices you make today can make a long-lasting impact on your future.
But, since the future is unknown (and retirement can be decades away) it’s hard to predict exactly which accounts give you the most tax benefits over the long run. That’s why we feel compelled to address a question we frequently receive, “should I invest in a Traditional IRA or Roth IRA?”
Each IRA has different rules/benefits and pros/cons but the main difference is:
- Traditional IRA —> allows you to make pre-tax contributions. Then later when you withdraw funds, you will pay all the built up taxes on those dollars.
- Roth IRA —> allows you to make after-tax contributions. By paying the taxes upfront you’ll be able to withdrawal your contributions (not the gains) tax-free at any point in the future! And you’ll be able to withdrawal all of your Roth money tax-free after the age of 59 ½.
Traditional IRA vs Roth IRA
If you’re wondering which IRA might work best for you, both have their unique pros and cons. Let’s break down the main differences below:
|TRADITIONAL IRA||ROTH IRA|
|Contributions can reduce *current year* taxable income Deductions can be phased out depending on incomeAt age 72, you MUST take withdrawals [called RMDs – more on this below]|
EARLY WITHDRAWALS: Any withdrawal prior to age 59½ is subject to income taxes + a 10% penalty (some exceptions apply)
|No tax break for contributionsHigher income earners not eligible for Roth (limits discussed below)All retirement withdrawals are tax free|
EARLY WITHDRAWALS: Contributions can be withdrawn at any time, however earnings and growth may be subject to a 10% penalty and income taxes if withdrawn before are 59½.
|Best Suited For:||Best Suited For:|
|If you expect to be in the same or lower tax bracket later in life||If you expect to be in a higher tax bracket later in life|
|2023 Contribution Limits||2023 Contribution Limits|
|$6,500 ($7,500 if age 50 or order) across both Traditional and Roth accounts||$6,500 ($7,500 if age 50 or order) across both Traditional and Roth accounts|
Here’s another way to think about it…
- Traditional IRAs —> act like a personalized pension. In exchange for considerable tax breaks *today* they restrict and dictate access to funds until later in life.
- Roth IRAs —> serve more like regular investment accounts—only with tax benefits. They let you access most of your money early but the big tax breaks come later in life.
IRA Income Limits
Depending on how much money you make, you may or may not be able to contribute to a Roth IRA. If your modified adjusted gross income (MAGI) exceeds a certain threshold, the amount you can invest is reduced, or even fully eliminated at higher income levels.
This isn’t the case for Traditional IRAs – there are no income limits. However, the amount you can deduct from your tax return phases out with higher incomes.
It sounds confusing, but here are the limits explained simply…
2023 Income Limits
- Traditional IRA —> Anyone with earned income can contribute, but tax deductibility is based on income limits and participation in an employer plan.
- Roth IRA —> Single-tax filers with MAGIs of less than $153,000 (phaseout begins at $138,000) and married couples filing jointly with MAGIs of less than $228,000 (phaseout begins at $218,000) are eligible.
More info directly from the IRA website: IRA income and contribution limits
IRA Withdrawal Penalties
- Traditional IRA —> penalty-free but taxed as current income after age 59½ (withdraws prior to 59½, you’ll pay taxes and a 10% penalty)
- Roth IRA —> Contributions can always be taken out tax and penalty free. Once you reach the age of 59½ you have full access to all of your Roth funds with no tax consequences.
There are two hurdles you must clear to withdraw investment earnings from a Roth IRA without penalty:
- You must be at least 59½ years old
- Your account needs to be at least five years old
That five-year rule is unique to Roths. How do you know when your account reaches its fifth birthday? The clock starts on the earliest date of these three events:
- The first time you contribute directly to your Roth IRA
- The day you roll over a Roth 401(k) or 403(b) to the Roth IRA
- The day you convert your Traditional IRA to a Roth IRA
NOTE: If you’re younger than 59½ and your Roth IRA includes money from multiple conversions, you must track each conversion separately in terms of the five-year holding period.
IRA Withdrawal Penalty Exceptions
Be aware that there are withdrawal exceptions (penalty-free withdrawals prior to age 59½) for Roth and Traditional accounts. You can avoid the penalty (but not the taxes) in some circumstances, such as:
- Using the money to pay for qualified first-time homebuyer expenses (up to $10,000)
- Paying for qualified higher education expenses.
- Cover expenses from the birth or adoption of a child
- Some medical expenses and healthcare premiums
- If you become permanently disabled
Here’s a full list of early withdrawal penalty exceptions from the IRS website!
What are RMDs?
A required minimum distribution (RMD) is the amount of money that must be withdrawn from a variety of retirement plans. That includes any employer-sponsored retirement plan, Traditional IRA, SEP, or SIMPLE individual retirement account (IRA) by owners and qualified retirement plan participants of retirement age.
Which IRAs Require RMDs?
- Roth IRA —> No required withdrawals for the account owner. Most account beneficiaries are subject to the RMD rules.
- Traditional IRA —> Distributions must begin at age 72 for the account owner. Beneficiaries are also subject to the RMD rules.
Roth IRAs carry no RMDs, which means you’re not required to withdraw any money at any age or during your lifetime. This feature makes Roth IRA’s ideal wealth-transfer vehicles. Beneficiaries of Roth IRAs don’t owe income tax on withdrawals; however, they are required to take distributions or they’ll need to roll the account into an IRA of their own.
With traditional IRAs you are required to take mandatory RMDs, taxable withdrawals of a percentage of your funds, at age 72 even if you don’t need the money. You must take your first RMD by April 1 the year after you turn 72. In subsequent years you must take your RMD by Dec. 31.
The IRS offers worksheets to calculate your annual RMD, which is based on your age and the size of your account.
Who Benefits Most from a Roth IRA?
Here’s when a Roth IRA might make the sense for you:
- The expectation is your tax bracket is smaller now than it will be in the future
- You are currently investing enough money to reach your annual contribution limits
- You want to lower your taxable income in retirement
- When retired, you don’t want mandatory distributions (no RMDs)
- The early withdrawal flexibility appeals to you
- You already fund a pre-tax 401(k), so having a Roth provides tax diversification
Who Benefits Most from a Traditional IRA?
Here’s why a Traditional IRA may make more sense for you:
- You’re making lots of money currently and you expect your tax bracket to be lower in the future
- You don’t have access to a 401(k) or other pre-tax retirement accounts
- You want to lower your taxable income for the present tax year
- Your income currently is too high for Roth eligibility
For most people, the biggest advantage of a Traditional IRA is the upfront tax break. But, later in life Uncle Sam will definitely come knocking to collect his portion… So unless you don’t qualify for a Roth IRA, there’s a pretty good chance it will work out better for most folks in the long run.
Creating Multiple Tax Buckets
For tax planning purposes it can be helpful to have multiple different types of accounts, pre-tax and post-tax. If you are investing in a traditional 401k that your employer offers, you’re creating a future nest egg that will be subject to taxation down the road.
Don’t let the tax tail wag the dog. It’s a good thing to be socking that money away! Still, many folks would be wise to open up a Roth IRA, which allows them to sock even more money away, but that brilliant move also allows for more future flexibility from a tax standpoint.
Having multiple accounts, both Roth and traditional, will provide you a greater array of options when you reach retirement age, potentially reducing your overall tax burden in a meaningful way.
Which IRA is Best for You?
Well, it really comes down to your personal situation. Here are some questions to ask yourself…
- Do you prefer the tax break *now* (Traditional IRA) or tax break *later* (Roth IRA)?
- Will you need access to early withdrawals before age 59½? (Roth allows you to take out contributions anytime without penalty)
- Will your income be higher in retirement than it is today? (I know that’s hard to predict, but what is your most realistic scenario?)
- Do you already contribute to a 401(k)? (If so, you’re already reducing your taxable income – so saving additional money in a Roth provides a bit of diversification)
Most people think that their gross income will decline in retirement, but taxable income sometimes does not. For example, you’ll be collecting (and possibly owing taxes on) Social Security benefits, along with potential income from investments.
Additionally, when the kiddos are grown and you stop funding your retirement nest egg, you lose some valuable tax deductions and tax credits. As a result, this could leave you with higher taxable income even after your full-time working days are over.
If you project you’ll be in a higher tax bracket when you retire, a Roth IRA may be the wiser choice. You’ll pay taxes now, at a lower rate, and withdraw funds tax free in retirement when you’re in a higher tax bracket. On the other hand, if you expect to be in a lower tax bracket during retirement, a Traditional IRA might make the most financial sense. You’ll reap tax benefits today while you’re in the higher bracket and pay future taxes at a lower rate.
The Bottom Line
So now we circle back to our age-old question – Should I invest in a Traditional or Roth IRA? The answer is, “It depends.” Determining which is best for you boils down to a little prognostication, attempting to envision whether your taxes are going to be higher now or in the future.
But relax, just the fact that you are saving in any tax advantaged account means you’re already ahead of the game. Nobody has a crystal ball and no-one knows what future tax rates will be. So make your best guess, sock away as much as you can into the account you choose, then keep on living your best life possible.
- Roll over your old 401(k) to an IRA
- The Beauty of the Roth IRA (podcast, 44 mins)
- End of Year Financial Checklist