IRAs, or Individual Retirement Accounts, are tax advantaged options for long term investments or retirement. The main difference between a Roth and Traditional IRA is simply how they are taxed. Picking between a Roth or Traditional IRA is a matter of preference on when and how to pay taxes on the contributions.
It is important to understand the differences between the two Individual Retirement Accounts so that you can make an informed decision. Choosing which IRA to select depends on several factors, let’s dive into the pros and cons to see which is the best for you!
How To Open an IRA
Opening an IRA is actually really simple to do — whether it be through your employer or through a brokerage of your choice, it can take only a few minutes to get started.
Your Employer
Since “I” stands for “individual”, you may assume that an IRA must be opened by yourself. However, there is a good chance that your employer can help you set up a traditional or Roth IRA with a financial institution.
To open an IRA through your employer, it is rather simple:
- You establish an IRA (either Traditional or Roth) through your employers’ benefits website
- You would need to authorize an amount or percentage of your income that would go into your IRA
- Your employer would provide your payroll deduction to the institution
Opening an IRA with a Broker
If you do not have access to an IRA through your employer, or if you just wish to open an IRA on your own — you can open it through a number of different brokerages. It only takes a little bit of time to open an account and start investing into your IRA. Some of the most common brokerages used to open either a Roth or Traditional IRA are:
Contributing to an IRA
To contribute to an IRA, you will just need to log in to your account and manually transfer funds over from your bank or credit union. This can also be set up automatically at each pay period. The only restriction is that you can only contribute to an IRA if you have income — any unearned income (rental income, alimony, interest or dividends, pension, etc.) cannot be contributed to an IRA.
Contribution Limits Roth IRA vs Traditional IRA
Once you have decided to open an IRA, you may be thinking about how much you can actually contribute. This depends on a few different factors:
Roth IRA
For 2019 and 2020: The total contributions you can make each year to all of your IRAs (both Roth and Traditional) can’t be more than: $6,000 combined (If you’re age 50 or older you can add $1,000 for catch up — $7,000 total)
Contribution Limits vary for a Roth IRA — Depending upon your MAGI (Modified Adjusted Gross Income).
Married filing Jointly:
- Up to the limit: Less than $196,000
- A Reduced Amount: Greater than or equal to $196,000, and less than $206,000
- Zero: Greater than $206,000
Single Head of Household or Married filing Separately:
- Up to the limit: Less than $124,000
- A Reduced Amount: Greater than or equal to $124,000, and less than $139,000
- Zero: Greater than $139,000
Traditional IRA
For 2019 and 2020: The total contributions you can make each year to all of your IRAs (both Roth and Traditional) can’t be more than: $6,000 combined (If you’re age 50 or older you can add $1,000 for catch up — $7,000 total)
Roth IRA vs Traditional IRA Taxes
The taxing of the IRAs is one of the main differentiators that you should consider. With a Roth IRA, you don’t have a tax advantage up front, but you are not taxed upon distributions (once you meet the qualified age). In Traditional IRAs, you have a tax advantage up front, but are taxed upon taking distributions.
Roth IRA Taxes
Roth IRAs allow you to pay your taxes up front, which means that all future withdrawals will be tax free, rather than tax deferred. All of your earnings in a Roth IRA are tax free, so when you hit the retirement age, you will not be taxed upon qualified distributions.
Traditional IRA Taxes
Contributions to Traditional IRAs are tax deductible. All earnings are taxed at the time of withdrawal. This is considered to be regular income tax, as opposed to capital gains tax.
Roth IRA vs Traditional IRA Age Limits
There are some stipulations when it comes to which age you can withdraw money out of your Traditional or Roth IRA. While both the Traditional and Roth IRA do not have restrictions on your contributions, they differ in how you make withdrawals.
Roth IRA Age Limits
- No age limit to open a Roth IRA
- There is no age limit to contribute to a Roth IRA
- Cannot withdraw from a Roth IRA until age 59.5 (If you do, there is a 10% penalty, as well as income tax, on any amount withdrawn)
Traditional IRA Age Limits
- No age limit to open a Traditional IRA
- There is no age limit to contribute to a Traditional IRA (starting in 2020)
- Cannot withdraw from a Traditional IRA until age 59.5 (If you do, there is a 10% penalty, as well as income tax, on any amount withdrawn)
- Required minimum distributions by April 1st in the year at which you turn age 72 (starting in 2020)
Withdrawing From a Roth IRA vs Traditional IRA
There may be many situations where you need to take a withdrawal from your IRA, but there are several things to consider. Whether you are waiting for retirement age, or considering an early withdrawal — these two forms of IRA behave differently.
Roth IRA
The Roth IRA is great for many reasons, especially when it comes to withdrawing your money. This includes:
- All of the growth is exempt from taxes (unless you withdraw prior to age 59.5, there is a 10% penalty and incur income tax on anything withdrawn)
- As long as you are 59.5, you can withdraw your money penalty and tax free!
- There is no requirement for withdrawal until after the death of the owner of the Roth IRA
- You can withdraw your contributions tax and penalty free at any point in time
This last point is very important to note because the Roth IRA can serve essentially as an emergency fund.
Traditional IRA
A traditional IRA has different requirements when it comes to withdrawals or distributions:
- Taxes are not taken on earnings or gains until any withdrawals from the IRA — which can occur at 59.5 years of age minimum
- There is a penalty of 10% on any earnings if taken prior to that age, similar to a Roth IRA (This money will be taxed as income as well)
- With a traditional IRA, there are required minimum distributions at the age of 72. (You will not have an option to withdraw your money or not, at age 72 you will need to start taking out at least the RMD)
Main Benefits For a Roth IRA or Traditional IRA
Roth IRA
- Benefit 1: No RMDs — required minimum distributions — as long as you are alive
- Benefit 2: Tax free distributions at the required qualified age of 59.5 years — including earnings on investments
- Benefit 3: No taxes on your actual contributions if you need to withdraw early (gains will be taxed however if withdrawn early) !
Traditional IRA
- Benefit 1: Can be fully or partially tax deductible in the year contributions are made
- Benefit 2: No income limitations for traditional IRA
- Benefit 3: Earnings will grow tax deferred — meaning you don’t pay income taxes on interest, dividend or capital gains until funds are withdrawn
Main Limitation For a Roth IRA or Traditional IRA
Roth IRA
- Limitation 1: Your Modified Adjustable Gross Income (MAGI) must be within a certain range (The range is set depending on if you are single vs. married)
- Limitation 2: No tax deductions — all of the contributions are post taxes (essentially out of pocket spending money)
Traditional IRA
- Limitation 1: You are forced to take required minimum distributions at age 72
- Limitation 2: You’re taxed in retirement on distributions
Tax Bracket Upon Retirement
Predicting where your tax bracket may be upon retirement may be a little difficult to do, unless you can see into the future. You will have to make your best educated guess on where you will be at the end of your career. It can be assumed that you will have a higher marginal income tax rate when you will be working, as opposed to living off of your retirement income, even though that isn’t guaranteed.
With a Traditional IRA, the withdrawals are taxed based upon your income in the year of the withdrawal. If you have a high tax bracket when you retire — you’ll most likely pay more in taxes. However, with a Roth IRA — if you wait to withdraw earnings until you are qualified for distributions, your tax bracket will not matter. Earnings from Roth IRA are not taxed, so this could be the best choice for you.