An Individual Retirement Account (IRA) is a tax-advantaged long-term saving account that allows you to save and invest for retirement. The two common IRAs are the traditional IRA and Roth IRA. Traditional IRA was established first in 1974 and then Roth IRA in 1997, getting its name from Sen. William Roth. These two tax-advantaged vehicles have several similarities but differ in key areas. Understanding how a Roth IRA is different from a traditional IRA is critical to know which is the best option for you. Let’s take a look at the key differences.
Pre-Retirement Withdrawals
In a traditional IRA, you’ll receive a 10% penalty and pay taxes if you withdraw your money before the age of 59½. In specialized cases, however, you can avoid the penalty, but the deductions will still be taxed. Such situations are qualified first-time home purchases or higher education expenses up to $10,000. Also, permanent disabilities and medical expenses can result in penalty waivers.
In contrast, Roth IRA allows you to make tax-free and penalty-free withdrawals even before you are 59½ years old. The conditions are that the withdrawals don’t exceed your Roth IRA contributions, and you’ve met the five-year holding period. Roth offers more lenient and easier early withdrawal rules.
Tax Benefits
Contributions in traditional IRA are made with pre-tax money, meaning you pay taxes on the back-end. Your investment grows without taxation; however, the tax is deferred to withdrawals after you reach 59½ years. Early withdrawals will also attract taxes. Traditional IRA is best for individuals who will be in a lower tax bracket after retirement.
In Roth, contributions are made with after-tax money, and your investment grows tax-free. After the five-year grace period, you can make tax-free withdrawals. However, before the age of 59½, you’ll be subjected to a 10% penalty for withdrawals of earnings unless you meet their tax waiver eligibility criteria. Withdrawing your contributions after five years won’t attract any penalty.
So, a Roth IRA is a better choice unless you’re an extremely disciplined saver. Both IRAs offer tax breaks. In Roth, you enjoy that benefit after retirement. In a traditional IRA, the tax benefit is delivered annually; thus, you can easily spend the money. To enjoy the same investment benefits of a Roth IRA in retirement, you would need to reinvest the money into the traditional IRA.
Income Requirements
If you are 18 or older and have earned income, you’re eligible for a traditional IRA. In 2022, the maximum annual contribution is $6,000 and $7,000 for those 50 years and over. In contrast, there are income limits for a Roth IRA. Anyone with an annual earned income exceeding $144,000 for single filers or $214,000 for married filers cannot be eligible for Roth IRA. The same maximum annual contributions apply for both IRAs.
Mandatory Distributions
After 72, a traditional IRA would require you to withdraw a required minimum distribution (RMD) amount from your tax-deferred investment every year. Failure to withdraw your RMD can result in a hefty 50% fine on the difference.
In Roth IRA, there is no mandated RMD, so you can withdraw your money as you desire.
Pros of Roth IRA
- Best for individuals in a high-tax bracket
- Contributions grow tax-free
- Doesn’t have RMDs
- Penalty-free and tax-free after five years
- Contributions can be made at any age
Cons of Roth IRA
- Isn’t available for low-income individuals
- Income thresholds limit who can contribute
Pros of Traditional IRA
- Available for all people 18 and over with earned income
- Contributions grow tax-deferred
- Tax-deductible contributions
- Gives you annual tax benefits
- The upfront tax break can be an excellent incentive for high earners
- Contributions can be made at any age
Cons of Traditional IRA
- Taxed withdrawals
- You are subjected to RMDs when over the age of 72
- Only penalty-free after 59½ years
- Upfront tax break can comprise your retirement saving goals
Bottom Line
In a fiscal sense, in a traditional IRA, you take advantage of tax benefits now, while in Roth, you enjoy tax-free withdrawals in the future. After reviewing the key differences, Roth IRA is a better choice offering more incentives to invest. You can withdraw your money tax-free even before retirement; there is no RMD; a lack of tax deduction can make you more disciplined at saving. However, Roth is available mainly for high-income individuals.
I hope this article was helpful and that you found it interesting. If you have any questions, we will be more than happy to answer them below.
All the best,
Pete