A traditional IRA vs. a Roth IRA: Everything you need to know
Traditional IRAs and Roth IRAs are both individual accounts that offer different tax benefits to people for retirement. Contributions that are made to traditional IRAs are made on a pre-tax basis. This allows your money to grow tax-deferred in the account until you begin taking distributions.
When you contribute money to a Roth IRA, your contributions are made after you have already been taxed. Your money can then grow in the account. When you retire, your distributions from a Roth account will not be taxed since the taxes were paid at the time that you contributed money to your Roth. These two types of accounts offer benefits to individuals who are wanting to save money for when they retire.
What is a traditional IRA?
A traditional IRA is a tax-advantaged retirement account that allows you to save money and to grow on a tax-deferred basis. People are able to contribute up to $6,000 per year to a traditional IRA annually when they are younger than age 50. After they are 50, they can contribute $7,000 per year.
People who contribute money to traditional IRAs are able to claim deductions on their taxes during the year in which the contributions are made as long as the investors are eligible. You cannot withdraw money from the account before you reach age 59 1/2, or you will face a 10 percent penalty. There are a few exceptions to the early withdrawal rule, however.
When you begin taking distributions from your traditional IRA, you will be taxed at your ordinary income tax rate at the time that you make the withdrawals. You must begin withdrawing money from your traditional IRA once you reach age 70 1/2.
What is a Roth IRA?
A Roth IRA is another type of IRA that has a few important differences from a traditional IRA. When you compare a traditional IRA to a Roth IRA, one of the first differences that will be apparent is that contributions that you make to a Roth IRA are made after tax while those that are made to a traditional IRA are made before taxes are paid. This difference means a couple of things.
While you can deduct contributions to a traditional IRA, you cannot deduct contributions that you make to a Roth IRA. Unlike a traditional IRA, you are able to withdraw your principal from your Roth account before age 59 1/2 without penalty. However, you will face a penalty if you withdraw the interest that you have earned.
Since you pay taxes at the time that you make contributions to your Roth account, you will not pay taxes when you begin taking withdrawals after you retire. There is no required minimum distribution from a Roth, and you are allowed to continue contributing to a Roth IRA after you turn 70 1/2.
Traditional IRA vs Roth IRA trends
According to the Investment Company Institute , the balance that people held in IRA accounts at the end of 2015 was $99,017. People who had Roth IRAs were likelier to make contributions to the accounts.
Among people who held IRAs, 26 percent of those with Roths made contributions as compared to 6.5 percent who made contributions to traditional IRAs. A little less than 12 percent of the IRAs in the study received contributions during the year, and nearly 24 percent of people who had these types of accounts took withdrawals from them.
One important thing to note is that experts recommend that people save approximately 20 times their annual incomes for when they retire. The average IRA balance that was found by EBRI indicates that many people fail to save enough money. Retirement planning should be something that people begin when they are young so that saving can become a lifelong habit.
Why are the differences between a traditional IRA vs Roth IRA important?
The differences between a traditional IRA vs Roth IRA are important to understand for a few different reasons. These accounts offer different tax benefits. Roth IRAs also have income limits, and traditional IRAs have maximum age limits.
Understanding the differences between a traditional IRA vs Roth IRA can help you to determine which of these two types of accounts might be better for you. Some people might want to have both types of accounts so that they can take advantage of the tax deductions from a traditional IRA and the tax-free withdrawals from a Roth IRA.
Account setup, contribution deadlines, and age limitations
When you compare a traditional IRA to a Roth IRA, you will find that setting up either type of account is a straightforward process. You will first need to decide where to open your traditional IRA or Roth IRA account.
After you have chosen the financial institution for your IRA, you will then need to decide whether to open a traditional IRA or a Roth IRA. You will then need to fund your account and choose your investments. If you decide to open a Roth IRA, you will first need to make sure that you are eligible to make contributions.
If you potentially earn more than the maximum income for making annual Roth contributions, you can still roll over savings from another account to create a backdoor Roth IRA. This can allow you to enjoy the ability to take tax-free withdrawals after you retire or to avoid taking distributions after you reach age 70 1/2.
Individuals may open traditional IRAs, and there are no minimum age requirements or maximum income limits. However, you have to be younger than age 70 1/2 to open a traditional IRA, and you cannot make contributions to a traditional IRA after you reach age 70 1/2.
Individuals also are able to open and contribute to Roth IRAs if they are eligible. Roth IRAs have maximum income limits. The phaseout of maximum Roth IRA contributions for single people begins at $122,000 with a maximum income limit of $137,000. For people who are married, the phaseout for maximum Roth IRA contributions begins at $193,000 with a maximum income limit of $203,000.
There are annual contribution limits for Roth IRAs and traditional IRAs. People who are younger than 50 can contribute a maximum of $6,000 per year to either type of account. People who are 50 or older are able to make catch-up contributions of an additional $1,000 per year for a total of $7,000 per year.
If you have both a traditional IRA and a Roth IRA, your total contributions to the accounts must be the maximum contribution or less. You cannot contribute the maximum annual contribution amount to both accounts. Something that is important to note is that rollovers do not count towards the annual contribution limit.
Taxes and deductions
When you compare a traditional IRA to a Roth IRA, you will notice that there are different tax benefits of the accounts. Money that is contributed to a traditional IRA goes in on a pre-tax basis. This allows your savings to grow tax-deferred, but you will pay taxes when you start making withdrawals at your ordinary tax rate.
A traditional IRA and Roth IRA comparison also reveals that contributions that are made to Roth IRAs are made after taxes are paid. This means that you will not pay taxes at the time of disbursement after you retire.
Contributions that you make to a traditional IRA may be deducted during the years in which they are made if you are otherwise eligible. Contributions that you make to a Roth IRA cannot be deducted on your tax return.
Withdrawals, borrowing, distributions, and penalties
When you compare a traditional IRA to a Roth IRA, you will also notice differences about withdrawals, distributions, and penalties. If you take a traditional IRA early withdrawal before you reach age 59 1/2, you will have to pay an early withdrawal penalty of 10 percent along with taxes on the amount withdrawn.
There are some traditional IRA early withdrawal exceptions, however. You may be able to take an early withdrawal from an IRA before you reach age 59 1/2 without paying a penalty in the following situations:
- You are disabled and can provide documentation of your disability and your inability to complete any substantial gainful activity;
- You have unreimbursed medical expenses that exceed 10 percent of your modified AGI;
- You are unemployed and have received unemployment compensation for at least 12 consecutive weeks, and you withdraw money from your IRA to pay for your health insurance premiums;
- You withdraw money to pay for qualified higher education expenses for yourself, your spouse, your child, or your grandchild;
- You withdraw up to a maximum of $10,000 for a first-time home purchase; or
- You are the beneficiary of an inherited IRA.
Roth IRAs are different in that you can withdraw your contributions prior to age 59 1/2 without incurring a penalty if you’ve owned the account for longer than five years. However, you will be taxed on your withdrawals. If you make a Roth IRA early withdrawal from an account that you’ve had for fewer than five years, you will have to pay an early withdrawal penalty of 10 percent unless you meet one of the previously described exceptions.
When you compare a traditional IRA to a Roth IRA, you will also notice differences between when you must begin making withdrawals. For traditional IRAs, you will start having to take required minimum distributions beginning on April 1 following when you reach age 70 1/2. Roth IRAs do not have required minimum distributions, and you can continue contributing to a Roth as long as you want.
Rollovers, conversions, and backdoor Roth IRAs
A traditional IRA compared to a Roth IRA must follow the IRA rollover rules from the IRS. The IRS has a rule that you can roll funds over from an IRA only once per year. However, this rule doesn’t apply to when you roll the money over from a traditional IRA to a Roth IRA.
Some people choose to complete conversions of their traditional IRAs to Roth IRAs so that they can enjoy the benefits of tax-free withdrawals after they retire. You are allowed to convert a traditional IRA to a Roth IRA, but you will be taxed at the time that you complete the conversion.
A backdoor Roth IRA allows you to convert your traditional IRA to a Roth IRA regardless of your income. If your income exceeds the limits for making annual contributions, you can convert your traditional IRA to a Roth IRA so that you can still enjoy the tax benefits of a Roth after you retire. Before you do this, however, your retirement planning should include a plan for how to handle the taxes that you will be assessed at the time of the conversion. It might make sense to spread it out over a couple of years so that you can pay lower taxes.
Advantages and disadvantages of a traditional IRA
Investing in a traditional IRA has advantages and disadvantages. Some of the advantages include the following:
- There is no minimum age to open a traditional IRA;
- Contributions are made on a pre-tax basis, so you won’t pay taxes when you make them;
- Contributions can grow tax-deferred; and
- You may be able to take tax deductions for your contributions.
The disadvantages of a traditional IRA include the following:
- You will be taxed when you begin taking withdrawals;
- The annual contribution limits are low;
- You will have to take required minimum distributions beginning at age 70 1/2; and
- You cannot continue contributing to a traditional IRA after age 70 1/2.
Advantages and disadvantages of a Roth IRA
Investing in a Roth IRA also has several advantages and disadvantages. The advantages of a Roth IRA include the following:
- You can withdraw contributions at any time without taxes or penalties;
- You can invest in almost anything that you want;
- Your withdrawals after you retire will be tax-free; and
- You are not required to take required minimum distributions.
The disadvantages of a Roth IRA include the following:
- Your contributions are not tax-deductible;
- You will have a relatively low annual contribution limit; and
- There are maximum income limits.
A couple of examples might help you to choose between a Roth IRA and a traditional IRA. If you are currently just starting your career and believe that you will be in a higher tax bracket when you retire, a Roth IRA might make more sense.
If you instead anticipate being in a lower tax bracket after you retire, a traditional IRA may make more sense. This can also give you the added benefit of claiming deductions and reducing your MAGI so that you might be able to take advantage of other tax incentives.
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