Whether your employer offers a 401(k) option or not, an Individual Retirement Account (IRA) makes it easy for you to save for retirement on your own or in addition to your employer-sponsored plan.
There are two main types of IRAs: a traditional IRA and a Roth IRA. In this article, we’ll take a look at each and help you decide which one is right for you.
Here’s What You Need to Know About Traditional IRAs vs. Roth IRAs
The main difference between a traditional IRA and a Roth IRA is when you pay tax on your money.
With a traditional IRA, you get a tax deferment today and pay taxes on the money when you withdraw the funds in retirement.
With a Roth IRA, you pay tax on the money now, but your investment grows tax-free, and you get to spend it tax-free in retirement.
“Our tax rates today are unusually low because we’re running a massive budget deficit. At some point, those tax rates will increase. That means there’s a good chance tax rates will be higher when you go to spend your nest egg in 25 or 30 years,” money expert Clark Howard says.
What you think about Clark’s prediction about the direction of tax rates will likely inform your decision about which kind of IRA you choose.
The two main types of IRAs are for individuals. But you can also establish a simplified employee pension (SEP) IRA, typically if you own a business or are an independent contractor. We’ve got a full write-up on the SEP IRA here.
For the purposes of this article, we’re going to focus exclusively on traditional and Roth IRAs.
Table of Contents
- Definitions of Traditional IRA and Roth IRA
- Contribution and Income Limits
- Required Minimum Distributions
- Treatment of Withdrawals
Definitions of Traditional IRA and Roth IRA
An IRA allows you to save for retirement with pre-tax money, often through a payroll deduction. By using pre-tax dollars, you lower your taxable income right now.
But you don’t get to escape taxes entirely. The tax is deferred until you withdraw the money from your IRA during retirement when, at least in theory, your personal income tax rate is lower.
Note that traditional IRAs and 401(k) plans are not mutually exclusive. You’re allowed to contribute to both a 401(k) plan at work and an IRA elsewhere.
If you don’t have access to a 401(k) or similar plan at work, that makes saving through an IRA even more important. If you don’t make saving for retirement a priority, you may have to delay that retirement.
As of this writing, you don’t have to stop making contributions at age 70 and a half — the old maximum age for traditional IRA contributions. Because of the federal SECURE Act, passed in 2019, there is no age limit for contributions.
The Roth IRA is named after William Roth, a U.S. Senator from Delaware who proposed it as an addition to the tax code in 1997.
With a Roth IRA, you contribute after-tax money: income you’re paying taxes on now. But once you’re retired and start withdrawing the money, it’s tax-free — as is any profit your investment has made.
As with a traditional IRA, you can have both a 401(k) at work and a Roth IRA elsewhere.
And you can continue contributing to a Roth IRA as long as you like. There’s no maximum age limit for contributions, provided you have earned income in the year you want to contribute.
Contribution and Income Limits
Both the traditional and Roth IRAs and let you contribute the same amount on an annual basis. See the latest contribution limits here.
In addition, both types of accounts allow you to contribute an additional $1,000 annually if you’re age 50 or older.
There are no firm income limits that would bar you from contributing to a traditional IRA. However, your contributions may not be fully tax-deductible depending on your modified adjusted gross income (MAGI):
- 2020 full deductibility – MAGI of $104,000 or less (joint) and $65,000 or less (single)
- 2020 partial deductibility – MAGI of up to $124,000 (joint) and $75,000 (single)
There are also different levels of deductibility for working and nonworking spouses of plan participants who are not covered by an employer-sponsored plan:
- 2020 full deductibility – MAGI of less than $196,000
- 2020 partial deductibility – MAGI of up to $206,000
See the full details here.
Meanwhile, IRS income limits state that you can’t contribute to a Roth IRA if you earn more than $139,000 as a single tax filer or $206,000 if you’re married and filing jointly.
That’s unless, of course, you do a backdoor Roth IRA!
A backdoor Roth is simply a name for the process of taking money in a traditional IRA, converting it to a Roth and paying the tax on it. We’ve got full details here.
Required Minimum Distributions
Our nation’s tax law requires investors to take a certain amount of money out of some types of retirement accounts every year when you reach a certain age.
The amount you have to take out is called a required minimum distribution (RMD).
For traditional IRAs, the age at which you must take RMDs was recently raised from 70.5 to 72 per the SECURE Act.
However, RMDs are not required for 2020 on your traditional IRA because of the economic upset surrounding the coronavirus. This is a one-time exception to the rule.
And as of late 2020, there are potentially more changes on the way.
No RMDs are required on Roth IRAs under the tax code — regardless of your age. That means if you don’t need the money from your Roth IRA, you can just let it grow.
Treatment of Withdrawals
Withdrawals from traditional IRAs are usually subject to taxes and a 10% early withdrawal penalty if you take money out before age 59.5.
Right now, however, you can draw down up to $100,000 from your traditional IRA before 59.5 without paying the 10% penalty. This is another special one-time exception for 2020 because of the coronavirus epidemic.
While the penalty is waived right now, you will still have to pay the tax, since you’re tapping pre-tax money. Fortunately, you’re allowed to spread out the tax liability over the next three years — yet another special one-time exception for 2020.
When it comes to Roth IRAs, you’re allowed to withdraw your contributions, but not your earnings, at any time and for any reason before age 59.5.
Since you’ve already paid tax on the money, you won’t be taxed further — provided it’s only the principal (your contributions) that you’re drawing down.
However, different rules apply for drawing down earnings before 59.5. You can read up on the full rules here.
The difference between a traditional IRA vs. Roth IRA really boils down to the question of taxes.
Do you believe you’ll be in a higher tax bracket when you retire? Then you’ll likely want to save through a Roth IRA, with its promise of a future tax break.
But if you’re confident your personal income tax rate will go down as you age, then you’re probably better off getting the tax benefit now that you get by saving through a traditional IRA.
Clark, of course, has his own feelings about the issue.
“Remember, in general, tax rates are likely to go higher over the years no matter which political party is in power,” he says. “That means it may make more sense to skip the deduction of a traditional IRA now to avoid tax later with a Roth IRA.”
Meanwhile, if you have additional investment and retirement questions, reach out to our Consumer Action Center.