IRA or Roth IRA: Which should you choose?

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What is the difference between a traditional IRA and a Roth IRA?

An IRA is an individual retirement account, which is a type of tax-advantaged savings vehicle that allows you to save for when you will retire. While there are several different types of IRAs, the two main types are traditional IRAs and Roth IRAs, and each type has its own benefits and limitations.

A traditional IRA is a type of account in which your contributions are made on a pre-tax basis. This means that you may be able to deduct your contributions from your taxes during the years in which they are made. Since you are not taxed at the time that you make contributions to a traditional IRA, your money has the potential to grow more over time. It is when you begin taking withdrawals in retirement that you will be taxed at your ordinary tax rate.

A Roth IRA is a type of account in which the contributions that you make are made on an after-tax basis. These contributions are not tax-deductible. A key benefit of a Roth IRA is that you will not have to pay taxes on your distributions when you begin to take them in retirement since the taxes were already paid. For Roth IRA contributions, your income limits dictate how much you can fund the account.

Which is better for your retirement account – Roth IRA or traditional IRA?

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The choice that is better for your retirement will depend on a few factors. If you believe that your income tax rate will be lower when you reach retirement than it is now, it makes sense for you to choose a traditional IRA so that you can enjoy tax savings now and pay lower taxes on the money in the future. There are no traditional IRA income limits as long as you earn an income.

If you believe that your tax rate after you retire will be higher, a Roth IRA may be a better choice since you will not be taxed on your distributions. This is also a better choice if you want to avoid taking withdrawals since Roth accounts do not have required minimum distributions while traditional IRAs do. Because of the Roth IRA limits, you might not be able to make regular contributions if your income is too high. However, these limits do not apply to conversions.

What should I be focusing on in comparing Roth vs. traditional IRAs?

There are several different things that you should focus on when you are comparing Roth and traditional IRAs. You should focus on including your current income tax rate vs. your future ordinary tax rate, the deductibility of your contributions, legacy options, and possible contribution withdrawals prior to reaching age 59 ½.

If you anticipate that your future tax rate will be lower than it is now and want to be able to make deductions as you contribute, a traditional IRA is the option for you. Conversely, if you think your future tax rate will be higher than it is now, a Roth IRA may be the better choice.

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If you want to be able to enjoy tax-free withdrawals in retirement, a Roth is a better choice. Under the Roth IRA rules, this type of account allows you to withdraw your contributions, but not your earnings, before you reach age 59 ½ without a penalty as long as you meet certain guidelines. By contrast, early withdrawals of your contributions from a traditional IRA will incur an early withdrawal penalty.

You also need to be aware of the income limitations for Roth IRAs. While traditional IRAs do not have maximum income limitations for eligibility, Roth IRAs set income caps. You are only able to contribute to a Roth as a single taxpayer if your income is $137,000 or less. As a joint taxpayer, your combined income cannot exceed $203,000.

Traditional vs. Roth IRA statistics

In the U.S., traditional IRAs are the most popular type of IRA, and Roth IRAs are the second-most popular. An estimated 33.2 million households in the U.S. own traditional IRAs, and 22.5 million own Roth IRAs. Overall, 41 million households own either type of IRAs, and another 11.6 million own both types of accounts.

In a survey that was conducted by the Teachers Insurance and Annuity Association of America, 45 percent of respondents reported that they believed that IRAs were too complicated to try to use them. When people were told that they could use their contributions to reduce their income taxes, 75 percent reported that they were likelier to consider an IRA.

Traditional IRA

When comparing traditional vs. Roth IRAs, there are a few important differences and similarities. A traditional IRA is a tax-advantaged method for people to save money for retirement. This is a type of retirement account that nearly any employed person can open. Several different factors will determine whether the contributions are deductible, including the following:

  • Your filing status
  • Whether you are covered under an employer-sponsored retirement plan
  • Your modified adjusted gross income or MAGI

The contribution limits for a traditional IRA are $6,000 per year if you are younger than age 50. If you are 50 or older, the maximum you can contribute is $7,000 per year. If the amount that you earned in compensation for the year is less than the maximum, the maximum amount that you will be allowed to contribute is an amount equal to your earnings.

There are a few tax rules that apply to traditional IRAs. If you are covered by an employer-sponsored retirement plan and make IRA contributions, they may be tax deductible based on your MAGI. If you are younger than age 50, your contributions to the traditional IRA may be deductible up to $6,000.

Taxes are paid on your earnings when you withdraw your money. Withdrawals from your traditional IRA are taxed as income. The rate that you will have to pay will be your ordinary income tax rate at the time when you take the withdrawals.

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If you withdraw money from your traditional IRA before you reach age 59 ½, you will have to pay a 10 percent penalty on top of your income taxes on the amount that you withdraw. There are a few exceptions to this rule, but most early withdrawals will be penalized.

Traditional IRAs also have required minimum distributions, which is a percentage of your total savings in the IRA that you are required to begin withdrawing after you reach age 70 ½. You are required to begin your RMDs by April 1 of the year that follows the calendar year that you reach age 70 ½. After that, you will have to take your RMDs by Dec. 31 of each subsequent year. If you fail to take your RMD, the penalty is 50 percent of the amount that you should have withdrawn.

There are a few benefits of a traditional vs. Roth IRA, including the following:

  • Ability to complete an IRA conversion to a Roth
  • Deductible for state and federal income tax purposes
  • Lowers your adjusted gross income
  • No traditional IRA income limits

Roth IRA

Comparing Roth and traditional IRAs reveal some important differences. There is no age limit on who can open or make contributions to a Roth IRA as long as you are working. You can continue to make contributions while you are working even after you reach age 70 ½. However, high earners may be limited or restricted from making contributions to a Roth IRA.

The contribution limits for a Roth IRA are $6,000 per year if you are under age 50 and $7,000 per year if you are older than age 50. if your compensation was lower than the dollar limit, your contributions are limited to the dollar amount of your earnings.

Under the tax rules, contributions to a Roth IRA are made after you pay taxes. This means that you will not be able to claim a tax deduction for your contributions, but your investments will grow tax-free.

Another important difference between IRA and Roth IRA is how the withdrawals are treated. You are able to take out your contributions tax-free at any time. Distributions from a Roth IRA can be taken before you retire under certain circumstances. A qualified distribution from a Roth includes the following:

  • Taken at least five years after the Roth IRA was first opened and you are at least 59 ½
  • Withdrawals of up to $10,000 to purchase or rebuild a first home for yourself, your child, or your grandchild
  • A distribution because of disability
  • Distributions to your estate after you die

When comparing Roth and traditional IRAs, another important difference is the required minimum distributions. Roth IRAs do not have any required minimum distributions after you reach age 70 ½ while traditional IRAs do.

Some of the benefits of a Roth IRA include the following:

  • Contributions can grow tax-free
  • Ability to create a backdoor Roth IRA
  • Tax diversification
  • Flexibility

IRA comparison table

To make it easier for comparing Roth and traditional IRAs, you can refer to this IRA comparison table.

Roth IRA Traditional IRA
Contributors age No age limitationsNot allowed during the year and after you turn 70 ½
Income limits$137,000 for single filers and $203,000 for married filers who file jointlyNo income limits
Contribution limits$6,000 per year if younger than 50 or $7,000 if 50 or older$6,000 per year if younger than 50 or $7,000 if 50 or older
DeductionsMade after-tax and are not deductibleMade pre-tax and may be deductible
Tax CreditEligible for saver’s tax creditEligible for saver’s tax credit
Tax DeferrableNot tax-deferrableContributions may grow tax-deferred
Early Withdrawal Penalties10 percent early withdrawal penalties before 59 ½ if they are not qualified10 percent penalties on withdrawals before 59 ½
Required Minimum DistributionsNoneBegin after you reach age 70 ½

Opening an IRA

To open an IRA account, you can choose between a traditional brokerage firm or a self-directed online platform. Traditional brokerages may charge high commissions and fees while self-directed online platforms may offer low or no fees. After you have chosen the institution at which you would like to open your account, choose the type of IRA that you want. Make certain that you understand the difference between IRA and Roth IRA so that you can pick the right type for your needs.

After you have opened your account, fund your IRA through your bank account or by rolling the funds in a different account into it. Choose your investments or pick from a selection of available portfolios.

The administrative fees that you might be charged for your IRA will vary by the provider. Maintenance fees may range from $25 to $100 per year, but providers will often agree to waive those fees if you maintain a minimum balance. Research online to identify providers that offer low fees or no fees or costs.

What is an IRA conversion?

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An IRA conversion occurs when you convert a traditional IRA to a Roth IRA. Since there are no income limits for IRA conversions, they are a way for people with high incomes to create backdoor Roth IRAs. Under the Roth IRA rules, conversions do not have income limits. However, if you roll funds over from one traditional IRA to another IRA, you can only complete one per year. Once you have recharacterized a traditional IRA as a Roth IRA, it cannot be undone.

Backdoor Roth IRA

A backdoor Roth IRA can be created by converting your traditional IRA to a Roth. People whose income is too high to qualify to make regular Roth contributions can create a backdoor Roth to enjoy better tax diversification.

Here is how to open a backdoor Roth:

  • Open and contribute to a traditional IRA
  • Complete tax form 8606 to make the contributions non-deductible
  • Convert the traditional IRA to a Roth IRA

You can contact the administrator of your traditional IRA to convert your traditional IRA to a Roth IRA.

What is an IRA rollover?

An IRA rollover refers to when you move funds from your existing employer-sponsored retirement accounts into a new IRA. You are allowed to do this with any qualified plan, including an employer-sponsored retirement plan, a 401(k), or a 403(b).

Your funds may be rolled over directly. With this type of transfer, the administrator of the 401(k) at your former job will pay the funds from your qualified plan directly to your new rollover IRA. Taxes are not withheld from funds that are rolled over. This type of transfer is the most efficient way to complete the process with the fewest potential tax consequences.

A 60-day rule applies when the plan administrator at your previous employer-sponsored plan sends you a check for the funds and you deposit the check into a new IRA within 60 days. As long as you deposit the funds within 60 days, you will not have to pay early-withdrawal penalties or taxes. If you do not, you will be taxed on the amount that was sent to you and may face a 10 percent early withdrawal penalty.

Gain knowledge about an IRA and a Roth IRA with M1 Finance. Start investing now, or call 312-600-2883.

Borrowing from an IRA

The IRS does not allow you to borrow from your IRA. IRA loans are prohibited. You cannot use your IRA or Roth IRA to fund a loan, and your IRA balance cannot be used as collateral. The IRS classifies these as prohibited transactions.

The contributions that you make to your Roth IRA are made after taxes. This means that you are allowed to withdraw your contributions to a Roth IRA at any time without penalty. However, if you withdraw your earnings, you will face the early withdrawal penalty.

Which one should I choose – IRA or Roth IRA?

The choice between a traditional IRA or a Roth will depend on many factors, including the following:

  • Your age
  • If you are under an employer-sponsored plan
  • If you want to go through a brokerage or self-direct your plan
  • Your investment goals

The best IRA is the one that is tax-efficient. If you will have a higher income when you retire than you do now, a Roth IRA may make more sense. This is because you can pay your taxes at your effective tax rate now instead of at the higher marginal tax rate you might expect to pay in the future.

However, if you believe that your income in retirement will be lower than your current income, a traditional IRA may be the right choice. This is because you can defer taxes now and pay them at a lower marginal tax rate when you begin taking distributions at a time when your effective tax rate is lower.

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