Choosing an IRA is important when planning for retirement but many people find it difficult to make the right choice. Before deciding between Roth and traditional IRAs, you want to know the features of both retirement arrangements and which is ideal for your situation. Here we will discuss the traditional IRA and Roth IRA so you can make an informed choice.
What Is an IRA?
IRA is an abbreviation of Individual Retirement Arrangement. With IRAs, you can defer taxes on your retirement savings. They provide a tax-deferred status for your employer-sponsored retirement savings such as a 401(k) plan when you change jobs. The most common types are the traditional and Roth IRAs.
Roth vs. Traditional: How to Choose
The main difference between Roth and traditional IRA is their tax benefits. With a Roth IRA, your withdrawals during retirement will be tax-free. Traditional IRAs allow you to deduct tax on any amount you saved in the account in the year of contribution.
Traditional IRAs provide instant tax benefits while Roth IRAs delay the tax break until you withdraw from your retirement savings. You want to choose the Roth IRA if your future tax rate will be lower. The traditional IRA is ideal if you expect to pay a higher tax rate when you retire.
It is difficult to know your retirement tax bracket. But the following considerations can help you determine whether to choose a traditional versus Roth IRA:
Determine IRA Eligibility
To be eligible for an IRA account, you need to earn income in that tax year. Earned income does not include proceeds of investments, interests, gambling, and other sources of money that are not work-related. The income you can contribute to an IRA must either come from a job or a business you own and run actively.
Contribution Amount
According to the 2024 guidelines, the contribution amount for Roth and traditional IRAs is $7,000 or $8,000 respectively. Your contribution can increase by $1,000 if you become 50 years or over during the tax year.
Age Limit
There are no age limits to contribute to a Roth IRA so long as you earn an income. However, only income earners below the age of 70 1/2 can contribute to a traditional IRA.
Income Restrictions
There are income restrictions if you want to use a traditional or Roth IRA.
Traditional IRA contribution limits include:
Income limits for single filers with Modified Adjusted Gross Income (MAGI) of
$64,000 or less: full deduction up to the contributed amount.
Over $64,000 but less than $74,000: IRS prorates the pre-tax amount.
Over $74,000: you can’t make pre-tax contributions.
Income limits for married joint filers with Modified Adjusted Gross Income (MAGI) of
$103,000 or less: full deduction up to the amount of contribution.
Over $103,000 but less than $123,000: IRS prorates the pre-tax amount.
Over $123,000: you can’t make pre-tax contributions.
There are separate rules if you are married but do not live with your spouse for parts or all of an entire year.
Roth IRA contribution limits (for tax year 2020) include:
Income limits for single filers with Modified Adjusted Gross Income (MAGI) of
$124,000 or less: You can contribute the maximum amount.
Over $124,000 but less than $139,000: IRS prorates the contribution amount.
Over $139,000: You can’t make Roth contributions.
Income limits for married filers with Modified Adjusted Gross Income (MAGI) of:
$196,000 or less: You can contribute the maximum amount.
Over $196,000 but less than $206,000: IRS prorates your contributions.
Over $206,000: You can’t make Roth contributions.
Roth IRA contribution limits (for tax year 2022) include:
Income limits for single filers with Modified Adjusted Gross Income (MAGI) of
$129,000 or less: You can contribute the maximum amount.
Over $129,000 but less than $144,000: IRS prorates the contribution amount.
Over $144,000: You can’t make Roth contributions.
Income limits for married filers with Modified Adjusted Gross Income (MAGI) of:
$204,000 or less: You can contribute the maximum amount.
Over $204,000 but less than $208,000: IRS prorates your contributions.
Over $208,000: You can’t make Roth contributions.
Tax Benefits
One of the reasons why Roth accounts are better is that they provide tax-free withdrawals because you pay tax on the savings. If you are sure of lower tax rates in retirement, this makes Roth IRAs a better choice. Traditional IRAs also provide a tax benefit in the year you made the contributions. While you will not pay tax on contributions to a classic IRA account, you will pay taxes on the withdrawals. Traditional IRAs work best if your tax rate in retirement will be higher than what you get during your active years.
Withdrawals
Roth IRAs allow you to withdraw your retirement savings after age 59 1/2 without taxes or penalties if the money has spent a minimum of five years in the account. Since there are no age restrictions for a Roth IRA, you can continue to contribute even if you don’t make withdrawals. This is one of the major benefits of Roth IRAs over the traditional IRA.
For traditional IRAs, you must withdraw a Required Minimum Distribution (RMD) from the account when you become 72 years old (note: it used to be 70 1/2, until the SECURE Act went into effect in 2020). And you pay tax on the withdrawals at the prevailing rate. So even if you don’t need the money, traditional IRAs force you to draw from the account when you reach a specific age.
When Should You Choose a Roth IRA?
Here are instances when it is better to choose a Roth IRA:
Choose a Roth IRA if you expect a higher tax rate when you retire. A Roth IRA allows you to withdraw your retirement savings tax-free since you have paid the tax upfront.
A Roth IRA is ideal if you will soon buy your first home. If your age is below 59 1/2, Roth IRAs permit you to remove $10,000 from your retirement savings to fund your first home purchase without penalties.
A Roth IRA allows you to withdraw your contributions during an emergency with no penalties. But you may want to seek your tax adviser’s counsel before making any withdrawals.
If you want to keep your money after 70 1/2 years, the Roth IRA is the ideal retirement plan. It doesn’t mandate RMDs like a traditional IRA.
When Should You Choose a Traditional IRA?
Here are situations where a traditional IRA is the ideal choice:
You expect a lower tax rate when you retire.
You want to enjoy the prevailing low tax rates.
You need money for an emergency, a first home, or specific expenses allowed under the traditional IRA regulations.
The Roth IRA is best for people who intend to use their money before they retire or tax-free withdrawals in retirement. It provides more flexibility and fewer penalties if you remove money for non-retirement related expenses.
The traditional IRA is ideal for big earners and people in a favorable tax bracket. Before you choose between a Roth vs standard IRA, talk to a tax professional about IRA differences to determine the product that best serves your situation based on your age, income, and other factors.
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