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Traditional and Roth IRAs

Jordan DeBoer

An IRA, or Individual Retirement Account, is a type of investment account that offers individuals a way to save for retirement with certain tax advantages. It's a personal account, which means it's owned by an individual, not an employer. IRAs come in different types, with the most common being Traditional IRAs and Roth IRAs. There are also SIMPLE IRAs and SEP IRA, but those are small business retirement plans and will be part of another post.

The 30,000 Foot Comparison

Traditional IRA: In a Traditional IRA, you can contribute pre-tax income, meaning the money you contribute reduces your taxable income for the year. This can result in a tax deduction, potentially lowering your current tax bill. The investments within the account grow tax-deferred, meaning you don't pay taxes on the gains until you withdraw the money in retirement. However, withdrawals in retirement are then treated as ordinary income and are subject to income tax.

Roth IRA: With a Roth IRA, you contribute after-tax income, so you don't get an immediate tax deduction for your contributions. However, the money you contribute grows tax-free, and qualified withdrawals (including earnings) are tax-free in retirement*. This can provide significant tax benefits in the long run, especially if you anticipate being in a higher tax bracket during retirement.

Both Traditional and Roth IRAs have contribution limits and may have eligibility requirements based on your income and whether you have access to an employer-sponsored retirement plan.

A spousal IRA (which is just a Traditional or Roth IRA in the spouses name) allows a working spouse to make contributions to an IRA on behalf of a non-working or low-earning spouse.

Lets see how they compare…

Tax Treatment of Contributions:

  • Traditional IRA: Contributions are often tax-deductible in the year they are made, reducing your taxable income for that year. However, you'll pay taxes on withdrawals in retirement.

  • Roth IRA: Contributions are made with after-tax money, so they are not tax-deductible. However, qualified withdrawals, including earnings, are tax-free.

Eligibility and Contributions:

  • Traditional IRA: Anyone with earned income can contribute, regardless of age. There are no income limits for contributing, but there are limits for deductibility.

  • Roth IRA: There are income limits for direct contributions. However, backdoor Roth IRA conversions can provide a workaround for higher earners.

  • 2024 Contribution limits across both types are $7000 and an additional catch-up of $1000 for those over age 50.

Tax Treatment of Withdrawals:

  • Traditional IRA: Withdrawals in retirement are taxed as ordinary income. This can lead to potentially higher tax liability in retirement. Withdrawals before age 59½ may incur a 10% early withdrawal penalty in addition to regular income tax, with some exceptions.

  • Roth IRA: Contributions can be withdrawn at any time without penalty or tax. *Earnings can be withdrawn tax-free if the account has been open for at least five years and you meet other requirements. Qualified withdrawals are tax-free, including both contributions and earnings. This can be advantageous for managing taxes in retirement.

Required Minimum Distributions (RMDs):

  • Traditional IRA: The age to start taking RMDs increased to age 73 in 2023 and to 75 in 2033.

  • Roth IRA: There are no RMDs during your lifetime, allowing the account to potentially grow for a longer period.

Impact on Current Taxes:

  • Traditional IRA: Contributions can reduce your current taxable income, potentially lowering your tax bill for the year.

  • Roth IRA: Contributions don't provide an immediate tax benefit, as they are made with after-tax money.

Tax Diversification:

  • Traditional IRA: Can be beneficial if you expect your tax rate to be lower in retirement than it is now.

  • Roth IRA: Provides tax diversification if you anticipate higher tax rates in the future.

Summary

This is a simple breakdown of what can certainly be a more thorough discussion on each topic. All of these points can be elaborated further, but hopefully this gives you a better understanding between these two popular IRAs. IRAs are a valuable tool for retirement planning, allowing individuals to invest for their future while enjoying tax advantages.

You can learn more about the specifics on IRA Contribution Limits directly from the IRS.

Ultimately, the choice between a Traditional IRA and a Roth IRA depends on many factors like your current financial situation, your future tax expectations, and your retirement goals.