An IRA is one of the simplest methods to begin saving for retirement. The type of account you choose can significantly impact how much money you receive when you stop working.
There are substantial differences between a traditional IRA and a Roth IRA. Each investor should understand these differences before deciding which account to open.
Traditional IRAs allow you to postpone paying taxes until you withdraw funds later in life. With Roth IRAs, you contribute after-tax money, and withdrawals are tax-free if the account has been open at least five years.
Traditional IRAs are preferable for people who expect to be in a lower tax bracket when they retire. Roth IRAs are best for those already in a lower tax bracket. They are often better for younger investors just starting their careers who expect to retire with higher incomes and higher tax rates.
Setting Up and Using an IRA
When deciding between a regular IRA and a Roth IRA, there is more to consider than just tax treatment. Both accounts allow investments to grow tax-free, with no taxes on capital gains or dividends while assets remain in the IRA.
IRAs are simple to set up and available at most banks, credit unions, investment firms, and online brokers. Automatic contributions can be scheduled, making retirement saving easier.
Unlike a 401(k) plan offered by your employer, an IRA allows you to choose your own investments. Many banks and brokers also provide support based on your retirement timeline.
An IRA can also complement an existing 401(k). Because a 401(k) offers the same tax advantages as a traditional IRA, adding a Roth IRA ensures you receive a tax break now and in retirement.
Roth IRAs allow trading in ETFs, bonds, stocks, and mutual funds. A self-directed IRA broadens the choices further, allowing investments in peer-to-peer loans, real estate, and certain precious metals. However, the IRS prohibits investments in collectibles such as stamps, diamonds, antiques, and life insurance plans.
If you file separately or did not live with your spouse during the year, the “single” status applies to your IRA deduction.
The deadline for contributions to both Roth and traditional IRAs is the same—April 15 of the following year.
Traditional and Roth IRA Advantages
Tax Deductions
Traditional IRA contributions are made pre-tax, while Roth IRA contributions are made after-tax. Traditional contributions can often be deducted from income, subject to certain restrictions.
Growth Without Taxes
Both Roth and traditional IRAs allow tax-free asset growth. No taxes are charged on capital gains or dividends while funds remain in the account.
Traditional and Roth IRA Disadvantages
Limitations on Contributions
Contributions are capped. For 2020 and 2021, the maximum was $6,000 per person, or $7,000 if age 50 or older. Eligibility to contribute to a Roth IRA may be reduced if modified adjusted gross income (MAGI) exceeds certain thresholds.
Penalties
Withdrawals before retirement age often trigger penalties.
- Traditional IRA: Withdrawals before age 59½ are taxed and penalized 10%.
- Roth IRA: Contributions can be withdrawn anytime tax-free and penalty-free, though earnings are restricted.
Required Withdrawals
Traditional IRAs require minimum distributions beginning at age 72. The required minimum distribution (RMD) is based on life expectancy and increases taxable income for that year. Roth IRAs do not have RMDs unless inherited.
Why Roth IRA Works for Many People
Roth IRAs offer greater withdrawal flexibility. Contributions can be withdrawn anytime without tax or penalty, though earnings withdrawals are restricted before retirement.
With a traditional IRA, early withdrawals almost always trigger taxes and a 10% penalty unless an exception applies.
For retirees, Roth IRAs have fewer restrictions. Traditional IRAs require RMDs starting at age 72. Roth IRAs do not, allowing savings to grow tax-free for as long as you live.
Roth IRAs also provide stronger after-tax benefits. The tax advantage is locked in at retirement through tax-free withdrawals, rather than annually like a traditional IRA. This structure reduces the temptation to spend tax benefits immediately.
Get Professional Help With IRA Decisions
Both Roth and traditional IRAs provide strong retirement benefits. Choosing between them depends on your current and future tax situation, as well as your retirement goals.
If you need professional help or advice on IRAs or other tax issues, contact Tax Law Advocates today. Our team of federally licensed enrolled agents, tax attorneys, and accountants work to resolve complex tax issues with both the IRS and state authorities.
