Traditional IRA vs. Roth IRA: Which One Is Right for You?
When it comes to retirement accounts, there are quite a few options to choose from. You may be offered a retirement plan at work…something like a 401(k), 403(b), 457, or SIMPLE IRA.
You also have the option to independently open your own retirement account. That’s where IRAs, or individual retirement accounts, come in. They’re a great way to build long-term wealth! And they often come with more investment options and fewer fees than an employer-sponsored account.
But between a traditional IRA and a Roth IRA, which one should you go with? What’s the difference between the two, anyway?
Let’s compare them, so you can make a decision about which type of IRA works well for you!
But first…
Before we get into the traditional vs. Roth comparison, I want to start by pointing out 2 important things:
You are allowed to have an employer-sponsored retirement account and your own traditional or Roth IRA.
With that being said, if your employer matches your contributions to their retirement plan, you should start there. If, for example, your employer will match your contributions for up to 4% of your income, figure out how much 4% is exactly. Then, make sure you’re contributing that much each year. That match is free money that’s being invested and growing exponentially over time. You want to make sure you’re taking advantage of that! 😉
Okay, now that we got that out of the way, let the traditional vs. Roth IRA comparison begin!
Similarities
I want to quickly point out how a traditional and Roth IRA are similar…
1. Both are meant for retirement
At the risk of stating the obvious, they’re both accounts meant for long-term investing so that you can grow wealth to use in retirement. BUT, to be clear, you don’t have to be retired in order to withdraw your funds from either account. Eligibility for withdrawals are based on your age, whether you’re still working or not.
2. Both have the same contribution limits.
Whether you have a traditional IRA or a Roth IRA, as of 2022, you can contribute up to $6,000 per year before the age of 50. If you’re 50 or older, you’re actually allowed to contribute up to $7,000 per year.
3. Both can help you grow your wealth substantially.
Whether you choose a traditional or Roth IRA, you can expect significant growth over time. Historically, the market has an average rate of return of 10% each year. With that type of average growth on your investments year after year for 20, 30, or even 40 years, you’d likely be in great shape no matter which type of IRA you go with! 😉
Differences
Now, let’s dive into the differences as well as why they might matter to you.
1. Income limits
Traditional IRA:
There is no income limit. You’re able to contribute to a traditional IRA, no matter how much you make!
Roth IRA:
Your income does impact your eligibility to contribute to a Roth IRA. What comes next is my attempt to keep this as simple and easy-to-understand as possible. Here goes nothing…
If your tax filing status is single, your MAGI (modified adjusted gross income) must be $129,000 or less in order for you to contribute the full $6,000. The higher your MAGI is above $129,000, the less you can contribute to a Roth IRA. Once your MAGI is $144,000 or more, you’re no longer eligible to contribute at all.
If your tax filing status is married, filing jointly, your MAGI must be $204,000 in order to contribute the full $6,000. The higher your MAGI is above $204,000, the less you can contribute. Once your MAGI is $214,000 or more, you’re no longer eligible to contribute to a Roth IRA at all.
Important note: Let’s say you open a Roth IRA when you are well within the income limits. Then, over the years, your MAGI increases to the point where you are no longer eligible to make contributions. Your Roth IRA is still yours to keep. There’s no penalty for having it. You just can’t contribute any more money to it. The money you already contributed over the years will continue growing, thanks to the power of good ol’ compound interest! 😃
Why does this difference matter to you?
If you don’t want to worry about income limits, and if you’d prefer to always be able to contribute to your IRA throughout your working years – no matter how much you make – then you may prefer a traditional IRA.
It is worth noting, though, that you have the option to start with a Roth IRA and then open a traditional IRA later if your income becomes too high to keep contributing to the Roth.
2. Tax advantages
Traditional IRA:
Your contributions are pre-tax. In other words, your contributions are deducted automatically from your paycheck, even before any taxes come out.
The money in a traditional IRA grows tax-free. No taxes are taken out as your money accrues interest upon interest. Cha-ching! 🤑
When you begin making withdrawals, the money is treated as income and taxed at that time.
So, to sum up, the money goes in tax-free and gets taxed later, when you take it out.
Roth IRA:
Your contributions are post-tax. You contribute money from your net (take-home) pay, which is money that has already been taxed.
The money in a Roth IRA grows tax-free. No taxes are taken out as compound interest does its thing to grow your money.
When you begin making withdrawals, you don’t pay any taxes on the money.
To sum up, the money goes in already having been taxed, so you don’t have to pay any taxes on it when you take it out.
Why does this difference matter to you?
Let’s say by the time you start making withdrawals, you plan to have a significantly lower income (or not be working at all). That means you’ll likely be in a lower income tax bracket. So, you may prefer to have a traditional IRA because if the money is taxed at a lower rate, you’re paying less taxes.
If you think you’ll still be working – and perhaps in an even higher tax bracket – by the time you start making withdrawals, then a Roth IRA might make more sense for you. You will have already paid taxes on it in the beginning. So, you can take the money out tax-free later, even if you’re in a higher tax bracket in the future.
Honestly, your preference here might also just be psychological. When the time comes, you may really like knowing that exactly what’s in your account is yours to take – no taxes involved. If so, you may prefer a Roth IRA.
3. Penalties
Traditional IRA:
You are not allowed to withdraw money from a traditional IRA until age 59 ½. If you do, you’re subject to a 10% penalty fee in addition to the withdrawals being taxed as income.😬
Roth IRA:
You can withdraw the money you contributed whenever you’d like, without penalty.
You just can’t withdraw any of your earnings (aka the interest that accrues as your money grows) before age 59 ½. If you do withdraw earnings before 59 ½, you’re subject to a 10% penalty in addition to those earnings being taxed.
Why does this difference matter to you?
A Roth can be particularly helpful if you plan to retire early. You can start pulling from your Roth contributions for some of the funds you’ll be living off of, without having to worry about penalties.
In general, if you’d like the freedom of having unrestricted access to the money you contribute, you may prefer a Roth IRA.
Buuuuut, I do have to say that pulling money from your Roth IRA for things other than retirement should be an absolute last resort. I’m talking an emergency that was greater than you could have ever planned for and more urgent than you could have imagined.
The longer that money is out of your account the more compound interest and growth you’re forfeiting…and it can make a pretty big difference in the end. 😔
4. Required Withdrawals
Traditional IRA:
By age 72, you are required to start making withdrawals, if you haven’t already. These are called required minimum distributions (RMDs).
Roth IRA:
There are no RMDs. There is no age by which you have to start withdrawing money from a Roth IRA.
Why does this difference matter to you?
You may already be sure that you won’t be working or have job-related income by age 72. So, you already plan to be withdrawing money from your IRA by that point anyway. If that’s the case, then RMDs won’t matter to you one way or another.
But, if you think there’s a chance you may still be working or will have other sources of income to use at age 72, then you may not want to start withdrawing money from your IRA at that point. Maybe you’d rather keep letting it grow so you can pass that money on to your kids and grandkids. More power to ya! 💪🏽
No matter what you’d plan on doing with that money, if you don’t want to be forced to start withdrawing it at 72, you may prefer a Roth IRA.
Final Note…
It’s perfectly legal to have both a traditional and a Roth IRA. Just be aware that the total you are able to contribute to the two accounts combined is $6,000 per year (or $7,000 if you’re age 50 or older).
Conclusion
In order to decide whether a traditional or Roth IRA is right for you, it’s important to understand the differences between the two. Hopefully, this breakdown helped you make sense of the differences regarding income limits, tax advantages, and withdrawal rules.
As you think about your particular circumstances and priorities, take these things into consideration in order to determine whether a traditional or Roth IRA is best for you!
Which type of IRA seems more appealing to you, and why? Share in the comments below!
