Understanding Traditional IRA vs. Roth IRA: What you need to know
Individual Retirement Accounts (IRAs) are popular investing vehicles for retirement savings. Among the various types of IRAs, Traditional and Roth IRAs are two primary choices, each with their unique features and tax implications. Let's dive into the key differences and considerations to help you understand which account may fit best in your financial plan.
Eligibility and Contributions:
To contribute to either of these accounts you must have “earned income”, which is essentially any taxable pay you receive from your employer or business. Contributions to a Traditional IRA are typically tax-deductible in the year they're made while the Roth contributions are not. This means that the amount contributed reduces your taxable income for that year, making them “pre-tax” and potentially lowering your tax bill. Before you make an IRA contribution to help reduce your taxable income, there is a combination of two things that can potentially affect if you are eligible to make the deduction. The first is if you can participate in an employer’s retirement plan like a 401(k). If that doesn’t apply to you then you don’t need to worry about the deductibility. However, if it does, you need to make sure you are under the IRA phaseout limits. The phase out limits for 2024 are listed below:
Single MAGI: $77,000 - $87,000
Married filing jointly MAGI: $123,000 - $143,000
Married filing jointly (only spouse is covered) MAGI: $230,000 - $240,000.
Contributions to a Roth IRA are the opposite of the Traditional IRA as they are not deductible in the year they’re made and funded with “after tax” dollars. There are some benefits to this that we will cover later. Roth IRA’s also have their own set of phaseout limits (listed below) to be eligible to contribute to the account. However, this is solely based on MAGI (Modified Adjusted Gross Income) and isn’t impacted by your participation in your employer’s retirement plan. If you are above the phaseout limits for both Traditional and Roth IRAs, you may still contribute with a Back Door Roth.
Single MAGI: $146,000 - $161,000
Married filing jointly MAGI: $230,000 - $240,000
Limits and deadlines:
The annual contribution limit for 2024 is $7,000 if you are younger than 50. If you are 50 and older you get an additional $1,000 each year. This limit is across all IRAs. If you have multiple Roth IRAs or one of each you are limited to $7,000 or $8,000 (50+) across all IRA’s combined. The contribution deadline for both Traditional and Roth IRA’s is the tax deadline of the following year. Example: You can contribute to an IRA for 2023 up until April 15th of 2024.nings.
Growth:
The Roth IRA and Traditional IRA are very similar when it comes to growth. The Traditional IRA grows tax deferred. This means any interest, dividends, or growth gets pushed down the road until you withdraw money from the account. The Roth IRA has tax-free growth. Since you contributed with “after tax” dollars, you won’t pay any taxes on the growth if you wait until you’re 59 ½.
Withdrawals and Withdrawal Rules:
Taxation: As mentioned previously, since you received a tax deduction for your Traditional IRA contributions the year you made it, any dollars you withdraw are subject to ordinary income taxation. The Roth IRA is exactly the opposite. You made the contributions to the account with dollars you already paid taxes on. This means any withdrawals from the account after 59 ½ are tax free.
Early withdrawals: Both accounts were created to help people save for their retirement in a tax-advantage manner. The 59 ½ rule was put in place to deter people from withdrawing their funds from retirement accounts for non-retirement purposes. The Traditional IRA is more restricting with early withdrawals due to the tax deductions you receive each year you contribute to the account. If you decide to take funds out of your Traditional IRA before 59 ½, they will impose a 10% penalty on top of the taxes you will already owe.
The Roth IRA has more flexible early withdrawal rules since the contributions are made with after-tax dollars. The principal amount of your contribution is always available to withdraw tax and penalty free. However, any earnings/growth you receive on your contributions are subject to tax and the 10% early withdrawal penalty if you are younger than 59 ½.
Roth IRA’s and Traditional IRA’s both have exceptions to the 10% early withdrawal penalty: Qualified Education Expenses and Birth or Adoption of a child to name a few. We recommend consulting with an advisor before making any early withdrawals, so you don’t accidentally incur the penalty.
Required Minimum Distributions (RMDs):
Because Traditional IRAs house tax-deferred dollars, they have a required minimum distribution (RMD). Currently these start at age 73. RMDs force the Traditional IRA owner to start withdrawing a small piece of your account from age 73 onward. The reason behind this is that the IRS wants their piece of the pie. This prevents your account from growing tax deferred forever. The Roth IRA doesn’t impose RMDs since you already paid the IRS their portion before it went into the account.
Which IRA Should I Be Using?
Now that you know the key differences between a Traditional IRA and a Roth IRA, I’m sure you are wondering which account is best for you. Let’s talk about it!
The general guideline is if you think your tax bracket will be higher when you retire than it is today, you should consider a Roth IRA. If you think your tax bracket will be lower when you retire you should use a Traditional IRA. However, there are other factors such as age, timeline, and growth that play key roles in this decision. An example is that a 30-year-old has a long timeline and has yet to reach their peak earning years. This usually pushes them more towards the Roth IRA. Another important consideration is that tax brackets historically have continued to go up so using a Roth IRA to lock in the known tax rate today could also be a good option.
Note: Due to the Tax Cuts and Job Act, we are currently in favorable tax rates. The TCJA is set to expire at the end of 2025.
Weighing your options
Let’s look at two examples to help piece together the information above.
Meet Sue:
Sue makes $75,000/year.
Sue is 35
Let’s assume she’s currently in the 22% tax bracket and will be in the 15% bracket (currently the 12%) when she retires.
She is going to contribute $7,000 to an IRA every year.
She needs help deciding if she should contribute pre-tax or Roth.
Let’s assume an 8% rate of return.
TABLE
Even though Sue’s tax bracket will drop in retirement it makes the most sense for her to contribute to a Roth IRA. This is due to the long-time horizon and compound growth she will receive over 30 years. She will end up saving approximately $73,000 in taxes by saving in a Roth IRA. Now let’s look at the same example except Sue is 55 and getting started saving for retirement.
TABLE
In this case with the shorter timeline, the account doesn’t have the chance to compound so the current tax savings outweigh the taxes you will have to pay at the time of withdrawal. Saving in a Traditional IRA saved Sue approximately $200 in taxes.
The Traditional and Roth IRA are powerful retirement savings vehicles, but picking the right one will add value to your financial plan. The examples we highlighted are black and white but the decision on what account is best for you can have some grey area. If you have questions about your situation or want to process a contribution for 2023 you can schedule a time to discuss with an advisor here.
