roth ira vs traditional ira

Roth IRA vs Traditional IRA: A Comprehensive Comparison

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Are you trying to decide where to invest your hard-earned money? Roth IRAs and traditional IRAs stand out as popular choices among the various retirement account options available. Each has unique features and benefits, so it’s important to understand the differences to determine which one best aligns with your financial goals. 

In this comprehensive guide, we’ll explore the key distinctions between Roth IRAs and Traditional IRAs, helping you decide which option is right for you.

 

What is a Roth IRA?

Roth IRAs offer tax-free growth and withdrawals in retirement, making them an attractive choice for many investors. Contributions to a Roth IRA are made with after-tax dollars, meaning you don’t get an immediate tax deduction. 

However, qualified retirement withdrawals, including contributions and earnings, are tax-free. Additionally, Roth IRAs do not have required minimum distributions (RMDs), allowing your investments to grow tax-free for as long as you like. 

What is a Traditional IRA?

Traditional IRAs, on the other hand, provide tax-deferred growth, meaning your contributions may be tax-deductible in the year they are made, reducing your current taxable income. However, you’ll pay taxes on contributions and earnings when you withdraw in retirement. 

Unlike Roth IRAs, Traditional IRAs are subject to RMDs, which require you to start taking distributions by age 73.

How are Roth IRAs and Traditional IRAs similar?

Both traditional and Roth IRAs have favorable tax advantages. Both allow tax-free growth of your contributions. 

Additionally, as long as you are under the income limits, both a traditional IRA and a Roth IRA allow an annual contribution of up to $7,000 for individuals under 50 years old and $8,000 for those aged 50 and above. It’s important to note that this contribution limit applies to the total amount across all IRA accounts, not to each account separately.

There are no age restrictions for either type of IRA. You simply need to earn an income equal to or greater than your contribution. Your teenage child working part-time as a server or dog walker can contribute to an IRA.

>> Are you trying to decide whether to contribute to your Roth IRA vs Traditional IRA? Here’s a FREE flowchart to help you decide.

What are the key differences between Traditional IRAs and Roth IRAs?
1. Taxes
The main difference between a Roth and a traditional IRA is when the taxes are paid. With a Traditional IRA, contributions can be made using pre-tax dollars (if you qualify), meaning they are deducted from your income in the contribution year. However, you pay taxes on your distributions at the time of withdrawal. 

Essentially, you defer taxes until retirement, allowing you to benefit from tax-deferred growth.

Conversely, a Roth IRA operates on a post-tax basis. Contributions are made with after-tax funds, so they do not reduce your taxable income in the year of contribution. However, withdrawals during retirement are tax-free, including any earnings on your investments.

For example, if you have an annual income of $77,000, contribute $7,000 to a Traditional IRA. This would reduce your taxable income to $70,000. Conversely, with a Roth IRA, your $7,000 contribution doesn’t lower your taxable income, so it would remain at $77,000.

An often-discussed aspect of the Roth IRA versus traditional IRA debate is that you’ll likely be in a lower tax bracket during retirement. While this scenario is plausible, it’s also challenging to accurately forecast your tax bracket several decades into the future.

2. Income limits
There are no income limits on contributions to a Traditional IRA, but there are income limits if you want to deduct the contributions from your taxes. There are income limits on a Roth IRA.

3. Early withdrawals
Roth IRAs offer greater flexibility with early withdrawals compared to Traditional IRAs. While withdrawing funds early from retirement accounts is generally not recommended, Roth IRAs allow you to withdraw contributions anytime without paying income taxes. However, withdrawing earnings early may result in taxation and potential penalties.

In contrast, Traditional IRAs impose stricter rules for early withdrawals. If you withdraw funds before age 59 1/2, you may face a substantial 10% early withdrawal penalty and income taxes, even if you only take out your contributions. Navigating early withdrawals from a Traditional IRA requires careful consideration and adherence to IRS regulations.

4. RMDs
A Traditional IRA has required minimum distributions (RMDs). This means that you must start taking distributions at age 73.  Failure to take these RMDs incurs a hefty penalty of 50% on the undistributed amount.

Conversely, in a Roth IRA, you can leave your retirement account untouched for as long as desired. This flexibility offers significant advantages during retirement, affording you greater control over withdrawals and enabling you to minimize tax liabilities effectively.

What factors should I consider when choosing between a Traditional IRA and a Roth IRA?

1. Do you expect to be in a higher tax bracket now or during retirement?

Consider your current and future tax situation. A Roth IRA may offer greater tax savings if you expect to be in a higher tax bracket in retirement. Conversely, a Traditional IRA’s upfront tax deduction may be more advantageous if you anticipate being in a lower tax bracket. 

The further you are from retirement, the more impactful the potential for compounded tax-free growth in a Roth IRA becomes a significant distinguishing factor. A Roth IRA can also give you flexibility on how much to withdraw from your pre-tax accounts, enabling you to control your tax bracket during retirement.

2. Are you eligible based on your income?

Roth IRAs have income limits that may restrict high earners from contributing directly. In contrast, Traditional IRAs have no income limits for contributions, but they may affect the deductibility of your contributions based on your income and participation in employer-sponsored retirement plans.

3. Do you want to withdraw your contributions tax-free at any time without penalties? 

Roth IRAs offer more flexibility when it comes to withdrawals. You have already paid taxes on your contributions so that you can withdraw those contributions (not earnings) without any penalties. This may be handy if you are in a real emergency and have no other money to draw from. Traditional IRAs, on the other hand, impose penalties on early withdrawals before age 59½, with certain exceptions.

4. How do you want your inherited IRA to be structured for your beneficiaries? 

Roth IRAs offer tax-free withdrawals for beneficiaries, while Traditional IRAs may result in taxable distributions to heirs. Therefore, when planning your estate and considering your beneficiaries’ financial well-being, it’s essential to weigh the tax consequences of each IRA type and choose the one that aligns best with your goals and needs.

Roth IRA vs Traditional IRA

RulesRoth IRATraditional IRA
EligibilityYou must have earned income.You must have earned income.
Age Limits For ContributionsNo age limits.No age limits.
2024 Contribution Limits$7,000 if under 50 and $8,000 if age 50 or older.$7,000 if under 50 and $8,000 if age 50 or older.
2024 Income LimitsEligible for full contribution: Single tax filers with modified adjusted gross income (MAGI) < $146,000 and married couples filing jointly with MAGIs < $230,000.Anyone with earned income can contribute. However, the tax deductibility is based on income limits and participation in an employer plan.
Tax TreatmentNo tax deductions for contributions. Tax-free earnings and withdrawals in retirement.Tax deduction in the contribution year. Tax-deferred earnings. Ordinary income taxes are owed on withdrawals.
Withdrawal RulesContributions can be withdrawn at any time during the tax year, tax-free and penalty-free. Earnings can be withdrawn tax-free after age 59½ as long as it’s been 5 years since your first contribution.Withdrawals are penalty-free beginning at age 59½.
Required Minimum DistributionNone for the account owner. Account beneficiaries are subject to the RMD rules.RMDs begin at age 73. Beneficiaries are also subject to the RMD rules.

Can I contribute to both a Traditional IRA and a Roth IRA in the same year?

You can contribute to a Traditional IRA and a Roth IRA in the same tax year if you meet the eligibility requirements for each type of account. The combined total of your contributions must not exceed the annual contribution limits set by the IRS.

However, it’s essential to carefully consider your financial situation and long-term retirement goals before deciding on the appropriate allocation between the two accounts. It’s important to seek guidance from a fee-only financial advisor who can help you make informed decisions tailored to your specific needs and circumstances.

Is it better to have a Roth IRA or a Traditional IRA?

Roth IRA may be a better choice if:

  • You expect to be in a higher tax bracket when you retire than your current tax bracket. You may also want to delay your tax benefits now for potentially greater ones in the future. 
  • You don’t want to take RMDs from your retirement account when you reach 73. 
  • You want the flexibility to withdraw your contributions at any time. 

A traditional IRA may be a better choice if:

  • You expect to be in a lower tax bracket when you retire compared to your current tax bracket, and you want to claim your tax benefits in the year you contribute to your retirement account.

Will you contribute to a Roth IRA or a Traditional IRA in 2024?

Choosing between a Roth IRA or a Traditional IRA requires careful consideration of your financial circumstances, tax situation, and retirement goals. While Roth IRAs offer tax-free withdrawals and greater flexibility, Traditional IRAs provide immediate tax benefits and may benefit individuals in lower tax brackets. Regardless of your type of retirement account, the key to successful retirement investing lies in consistent and frequent contributions.

If you want a comprehensive financial plan, schedule a free discovery consultation with one of our fee-only financial planners today.

Best Financial Planner Washington DC

Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.

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District Capital is an independent, fee-only financial planning firm. We help professionals and entrepreneurs in their 30s and 40s elevate their finances and maximize their money. We are based in Washington, D.C and we work with people virtually nationwide.

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