Building up your retirement savings serves as a central pillar of financial planning. Saving up monies during the working years will provide individuals with both peace of mind and a source of income and comfort when they reach their golden years. An Individual Retirement Account (also known as an IRA) is a savings account specially designed to encourage you to both save and invest for the future. Two of the most common types of IRAs are the Traditional IRA and Roth IRA.
Read on to learn about what these plans have in common and where they differ in order to understand if one of them could be right for you.
What is an IRA?
An IRA is a special type of account that is geared towards investors looking to invest monies for retirement. There are special rules that are part of both the Traditional and Roth IRA packages.
First and foremost, IRAs contain an explicit tax benefit to incentivize individuals to put money away for later. There is a fundamental difference between Traditional and Roth IRAs in this regard, but the common denominator is a meaningful savings in tax obligations.
Secondly, these monies are meant to remain invested in the IRA until the investor reaches the age of 59.5. In addition, they are meant to be invested for at least 5 years. Monies can be removed, but there will be a penalty imposed. (These will sometimes be waived in cases of financial hardship.)
Lastly, there are monetary caps on the amount of monies that can be invested every year in an IRA. In 2024, the maximum contribution for those under 50 years of age is capped at $7,000 per year. Those 50 or over can contribute up to $8,000 per year. However, there is a slight twist in the amount that can be contributed on an annual basis between the two types of plans. (See below for details.)
IRAs can be established with a brokerage, bank, or other financial institution that engages in this type of work. Once the money is in an IRA, it can be invested in all sorts of different types of assets depending on the options that the financial institution offers for its investors. This can vary based on the level of risk the investor is comfortable with taking, and can range from ultra-conservative sovereign bonds to more aggressive strategies focusing on small cap stocks or emerging markets. The key fundamental is that the money is meant to be contributed and left to earn wealth, taking advantage of the incredible powers of compound interest (whereby monies remain invested and begin to earn their own set of earnings).
What is the Difference Between a Roth and a Traditional IRA?
There are a couple of key distinctions between a Roth IRA and a Traditional IRA, which relate to contributions, withdrawals, and taxation.
Contributions: The maximum annual contribution limits for both Traditional and Roth IRAs are the same, as noted above. But there is an asterisk. For Traditional IRAs, there is no income limit. No matter how much income someone is making, they can contribute up to the maximum amount every year.
For Roth IRAs, however, maximum contributions begin to taper off and eventually reach zero once a certain level of income is reached. In other words, those earning above a specific level of annual income are not able to directly contribute to a Roth IRA. The IRS publishes these numbers and limits on its website. There are different limits based on filing status, with a higher limit for those who are married and filing jointly, versus those who are single tax payers.
Taxation: In practice, similarly to Traditional 401(k) accounts, the monies invested into a Traditional IRA account are tax deductible. In other words, someone earning an income of $70,000 who contributes $4,500 will only pay income taxes on $65,500 for that tax year.
For both Traditional 401(k) accounts and Traditional IRA accounts, investors will pay taxes on the monies when they withdraw their payments once retirement rolls around. These are known as distributions, and they will be taxed as ordinary income.
When it comes to Roth IRAs and Roth 401(k) plans, however, the chronology is reversed. Unlike with the Traditional option, savers will not receive a tax break on their initial investment. In the above example, regardless of how much an individual has contributed to her Roth IRA (let us say the maximum of $7,000 for an individual under the age of 50), she will still be taxed on the entire $70,000 of earned income.
But, the order of the benefits is also reversed.
Once Roth IRA investors reach the age of retirement and begin to take distributions, they will not pay any taxes on the monies that have accumulated. This includes capital gains and any dividends that they earned over time within this investment account (assuming that the monies were invested for at least 5 years and only withdrawn after the age of 59.5).
Withdrawals: The government wants to encourage future retirees to keep their savings invested, at least until they reach the age of 59.5. For that reason, the government imposes a 10% penalty if monies are removed prematurely.
For those invested in Traditional IRAs, withdrawing funds before reaching the age of 59.5 will trigger both ordinary income taxes on these monies AND an additional 10% penalty. As an example, if a 58-year-old removes $1,000 from his Traditional IRA, these funds will be taxed as regular income tax and he will need to pay an additional $100 penalty (equivalent to 10% of $1,000).
Roth IRAs are composed of after-tax dollars, however, meaning that savers have already paid taxes on these monies. They can therefore withdraw the contributions they have made before turning 59.5 without incurring any penalty or tax. However, the monies that they will have earned from their investments will be subject to both taxation and the aforementioned 10% penalty.
For example, if Sarah’s initial $500 investment has turned into $1,000 in her Roth IRA account, and she decides to withdraw all her money from the Roth IRA, she will pay income tax on $500 of earned income as well as a $50 penalty (equal to 10% of the $500 gains).
Roth or Traditional: Which is Better?
Deciding between a Roth or Traditional IRA therefore comes down to a couple of considerations that revolve around taxes, flexibility, and an individual’s current financial situation.
Those who believe that their tax bracket is higher now than it will be in retirement might be better off going with the Traditional IRA option. They will save on taxes now, and likely pay a lesser amount in the future.
On the flip side, those who believe that their tax obligations will be higher once they begin receiving distributions would probably be better off going with a Roth IRA. They will pay a smaller amount now than they would be on the hook for in their later years.
Those in a higher income bracket will not be able to contribute directly to a Roth IRA. However, they could still transfer monies into a Roth IRA through what is known as a “back-door IRA.” (This can take place by moving monies from a 401(k) or Traditional IRA into a Roth IRA.)
Another important consideration, though, is the current financial status of the individual investor. For those struggling to pay their monthly bills now–or those who are servicing high-interest debt—the future benefits of the Roth might not be as worthwhile.
Another item to consider is the concept of Required Minimum Distributions. Roth IRAs (now) and Roth 401(k) plans (starting in 2024) will no longer have Required Minimum Distributions, which mandates a minimum withdrawal from retirement accounts every year after an individual turns the age of 73 (barring a few exceptions). While this does not impact most individuals, it is another consideration to take into account.
Conclusion: Understanding the Difference
Both Traditional and Roth IRAs have their advantages, and making the decision between one or the other will come down to a number of considerations. The key point–with both options–is to start as early as possible to ensure that the the golden years are ones to savor.
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