Traditional IRA vs. Roth IRA: What You Need to Know

Roth IRA vs Traditional IRA: At A Glance

With so many different retirement plans and savings accounts available, picking the right product can seem impossible — especially when many of them come with different tax advantages. This guide covers everything you need to know about picking a Roth IRA vs. a traditional IRA and should help give a better idea of which option is best for you.

What is the difference between a traditional and Roth IRA?

An IRA, or Individual Retirement Account, is an investment account you can use to help save for retirement. If you’re familiar with having a 401(k) through your employer, an IRA is similar. However, unlike a 401(k), IRAs are opened by individuals and do not involve your employer (hence the name – individual!).

IRAs come in two main flavors: traditional and Roth. The main difference is that a traditional IRA is typically funded with tax-deductible contributions, meaning you won’t pay taxes on the money until you withdraw or cash it out later. A Roth IRA, on the other hand, is funded with after-tax contributions, so your money can grow and later be withdrawn tax-free.

Almost anyone can open IRAs, though there are some eligibility and contribution rules. Primarily, you’ll need to have earned income for the year. They’re also a popular option for those transferring an old 401(k) — this is called a rollover.

In most cases, you’ll have to roll your 401(k) over into a traditional IRA to match the original account’s tax type, but there are exceptions to this rule if you’ve been contributing to a Roth 401(k). In that event, you’d need to open a Roth IRA to receive your rollover. You can use your Social Security Number to find an old 401(k) if you’ve forgotten who your provider is.

The rest of this guide will help answer your questions on the key differences between traditional IRAs and Roth IRAs.

Key differences between Roth and Traditional IRA

Before we get into all the details, let’s outline some of the key points about Roth and traditional IRAs:

Want all the details? Keep reading for the full scoop.

Roth v. Traditional IRA: Eligibility and Contribution Rules

Traditional and Roth IRA accounts have slightly different rules when it comes to eligibility and yearly contributions.

Pretty much all taxpayers are eligible to make contributions to a traditional IRA. You just have to have a taxable income equal to or greater than the amount you contribute.

Roth IRAs, on the other hand, have eligibility limits based on your adjusted gross income, or AGI, as well as your tax return’s filing status. For 2023, single filers become ineligible to make Roth contributions if they earn over $153,000, and those married filing jointly become ineligible if they earn $228,000 or more.

However, there is a tactic called a “backdoor Roth IRA,” which is when you contribute after-tax money to a traditional IRA and then convert the traditional IRA into a Roth, effectively circumventing the rules for direct Roth IRA contribution. Note that this only works tax-free if you have no other traditional IRAs at the time of Roth conversion.

For both types of accounts, there are strict IRA contribution limits that apply to all the IRAs you might have. For example, in 2023, the contribution limit is $6,500 per year, or $7,500 for those aged 50 or over. So, if you had two IRAs, you could contribute $3,250 to each, or $5,000 to one and $1,500 to the other, etc., as long as you don’t exceed the total limit for the tax year.

To recap, here’s a summary of your limits based on age:

Another important difference is how you can – or can’t – deduct your contributions from your taxes. Traditional IRA deductions depend on your income level and tax status (single, married, etc.). You’ll be able to take a full deduction for your contribution, a reduced deduction, or potentially no deduction depending on your total income tax situation.

Your Roth IRA contributions, on the other hand, are never tax-deductible. Remember, your Roth contributions are always made post-tax so that your withdrawals in retirement are tax-free – including your investment gains!

Can I have both a Roth IRA and a traditional IRA?

Yes! But as we mentioned, you can’t exceed the total annual contribution limits outlined above, no matter what blend of IRA types you might have. Keep in mind that you may need both a traditional and a Roth IRA if you’re rolling over an old 401(k).

For instance, maybe some of the retirement savings in your existing account are pre-tax, while others are post-tax. In that case, you’ll need both a traditional rollover IRA and a Roth IRA so that all of the funds keep their same tax status: traditional (pre-tax) to traditional; Roth (post-tax) to Roth.

Withdrawal Rules for Traditional and Roth IRAs

Both traditional and Roth IRAs are designed to help you save for retirement, so they’re subject to special rules about when and how you can make withdrawals.

Generally speaking, you can’t take distributions from an IRA before reaching age 59 ½ without paying an early withdrawal penalty of 10%, in addition to any taxes you owe if it’s a traditional IRA. There can be special exceptions, such as in cases of medical or financial hardship. The specifics will depend on your plan.

There are, however, some important nuances for Roth and traditional IRAs.

Because you’ve already paid taxes on the money you contribute to a Roth, you can take out Roth contributions at any time without paying taxes or an early distribution penalty. However, any earnings you withdraw from a Roth before age 59 ½ will get hit with that 10% penalty.

Furthermore, Roth IRAs aren’t subject to Required Minimum Distributions, or RMDs. Required Minimum Distributions force those who hold traditional IRAs to begin making withdrawals once they reach a certain age (currently 73). Roth IRAs aren’t subject to RMDs, which makes them ideal for passing on assets to heirs.

Keep in mind that no matter whether you choose a Roth or traditional IRA — or both — you’ll still have to pay taxes on the money at one point or another. It’s just a question of when.

Are there any special Roth IRA tax benefits?

Roth IRAs allow your funds to grow tax-free and also allow you to make tax-free and penalty-free withdrawals once you reach age 59 ½. But in order to make contributions to a Roth, you’ll have to pay income taxes on the money today, instead of getting a current-year tax deduction like you would for your traditional IRA contributions.

When deciding whether a Roth or traditional IRA is right for you, think about your tax bracket. Retirement funds are taxed as regular income, so you’d ideally want to pay your taxes when your taxable income is at its lowest. As a general rule of thumb:

• If you’re making more money now than you think you will when you withdraw, it might make sense to fund a traditional account – you’ll pay taxes later at a lower tax rate.
• If you’re making less money now (and in a lower tax bracket) than you think you’ll make when you withdraw, a Roth may help you save taxes in the long run because you’ll pay taxes now at a lower tax rate.

Of course, the decision depends on your individual financial situation. If you aren’t sure, consider asking an experienced financial advisor or qualified tax advisor for help.

Is a Roth IRA better for taxes than a Traditional IRA?

Both a Roth IRA and a traditional IRA will help prepare you for retirement while minimizing taxes. Because Roth IRAs offer tax-free growth — and the potential for tax-free IRA withdrawals — you might assume that a Roth IRA is always the best option. However, contributing to a traditional IRA can result in a current-year tax break (though, sometimes it does not). So, the “best” option for tax savings depends entirely on your personal situation.

Picking between a Roth IRA and Traditional IRA

Whether you choose a traditional IRA or a Roth IRA, there are several factors to consider when opening an account:

• Do you want an automated IRA (where investment decisions are made for you, like by a robo-advisor ), or a self-directed IRA (where you can allocate assets yourself and choose which stocks, bonds, ETFs, or mutual funds to purchase)? Automated IRAs provide ease of use, whereas self-directed accounts offer more control; it’s up to your personal preferences.
• How easy is the account to access and use? Each provider has a different set of tools to control and manage your account, and some are more user-friendly than others.
• What are the fees involved? You may have to pay annual maintenance fees, trade fees, and commissions, or maintain a minimum balance in the account.

You have plenty of options, so make sure you do your homework to find the financial planning guidance that works best for you and your personal finance goals.