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One pitfall of most investment accounts is that you must pay taxes any time you sell investments for a gain, or you receive dividend payments. Individual retirement accounts, or IRAs for short, are great options for those looking to defer taxes. They are primarily designed to help people without 401(k)s save for retirement, but they can also help you save on taxes.
There are two types: traditional IRAs and Roth IRAs. Both provide tax-free investment growth, which leaves you with more of your money to compound over the years until you need it. But how do you decide which of the two types is best for you? While they are similarly useful in a lot of ways, there are also a few notable differences, which are outlined below.
Taxes
Traditional IRA
Having a traditional IRA allows you to contribute money to your account that has not yet been taxed (pre-tax income). These contributions are often fully tax-deductible on both state and federal tax returns for the year you make them, depending on your income and whether you (or your spouse, if you’re married) are covered by an employer-sponsored retirement plan, such as a 401(k). But generally, traditional IRAs reduce your taxable income for the year. In return, your adjusted gross income (AGI) lowers. This might help you qualify for further tax incentives, such as the child tax credit or the student loan interest deduction.
Now, you do have to pay the taxman eventually. With traditional IRAs, your taxes are taken out of your distributions in retirement. The amount taken is determined by your income tax rate. Also, in return for these considerable tax breaks, traditional IRAs restrict and dictate your access to your funds, which will be discussed in further detail shortly.
Roth IRA
Conversely, Roth IRAs allow you to contribute funds on which you’ve already paid income taxes (post-tax income). Therefore, you receive no immediate tax savings. But once you retire, your withdrawals are tax-free. Essentially, since you paid your tax bill upfront, you can sail smoothly through retirement with one less thing to worry about. Plus, these accounts have fewer restrictions than traditional IRAs.
Early Withdrawals
Traditional IRA
If you withdraw money from your traditional IRA before age 59½, you’ll have to pay the income taxes on it and will likely be required to pay the IRS a 10% early withdrawal penalty. You must pay the taxes, but you can avoid the penalty in some specialized circumstances, such as when you use the money to pay for:
- Qualified first-time homebuyer expenses (up to $10,000)
- Qualified higher education expenses
- Permanent disabilities
- Certain levels of unreimbursed medical expenses
Roth IRA
Flexible early withdrawals are a big advantage of a Roth IRA. Since this account is funded with money that you’ve already paid income taxes on, you can withdraw sums equivalent to the amount you’ve contributed penalty- and tax-free before the due date of your tax return, for any reason, even before age 59½. However, you are subject to being penalized and taxed if you withdraw earnings. Earnings are sums above the amount you’ve contributed to your Roth IRA. These penalties can be avoided if you’ve had your Roth IRA for at least five years and one or more of these circumstances applies to you:
- You are at least 59½-years-old
- You have a permanent disability
- You die and the money is withdrawn by your beneficiary or estate
- You use the money (up to a $10,000-lifetime maximum) for a first-time home purchase
If you’ve had your account for less than five years, you can still avoid being penalized if:
- You’re at least 59½-years-old
- The withdrawal is due to a disability or certain financial hardships
- Your estate or beneficiary made the withdrawal after your death
- You use the money (up to a $10,000-lifetime maximum) for a first-time home purchase, qualified education expenses, or certain medical costs
Being able to make these withdrawals from your Roth IRA without being penalized or taxed means this type of account can also function as an emergency fund. Although, it is best to avoid doing so for anything less than an emergency – especially if the account is your primary or only way of saving for retirement. Don’t rob your future self of funds that could be saved, and compounded upon, for retirement!
Required Minimum Distributions
Traditional IRA
Required minimum distributions (RMDs) are mandatory, taxable withdrawals of a percentage of your funds. With a traditional IRA, you must start taking RMDs – regardless of whether you need or want to – once you hit a certain age. If you were born between 1951 and 1959, this age is 73. If you were born 1960 or later, it’s 75. Your RMD percentage is based on your age and the size of your account. The IRS offers worksheets that can help you calculate what your number will be.
Roth IRA
Roth IRAs carry no RMDs, which means you’re not required to withdraw any money, at any age, ever. This really makes Roth IRAs stand out from the crowd as all other tax-advantaged retirement accounts require you to begin withdrawing funds in your 70s. Avoiding this requirement can be a significant advantage in retirement.
Income Limits
Traditional IRA
Some investment accounts have income-eligibility restrictions. When it comes to traditional IRAs, this is not the case. A huge benefit of them is that anyone with earned income can contribute.
Roth IRA
On the other hand, Roth IRAs do have income-eligibility restrictions. To open an account in 2023, single filers must have a modified adjusted gross income (MAGI) of less than $153,000, with contributions phasing out starting with at $138,000. Married couples must have MAGIs of less than $228,000, and contributions phasing out starting at $218,000.
Which IRA Is Best for You?
So, now that you know more about the biggest differences between the two IRAs, which of these should you use as deciding factors? First, if you don’t meet the income-eligibility restrictions for a Roth IRA, then right away you know that a traditional IRA is your only option. If you do quality for both, the next thing to consider is whether your annual income and tax bracket will most likely be lower or higher once you retire.
Basically, it comes down to trying to predict when tax breaks will be most beneficial for your budget. Now, this is easier said than done. Although income – and therefore your tax bracket – typically lowers in retirement, that is not always the case. Some variables that could result in you having a higher taxable income in retirement than you do now include:
- Social security benefits
- Investments
- Consulting or freelance work
- Loss of previously applicable tax deductions and credits
After taking those variables into account, if you think you’ll be part of this group of people who end up in a higher tax bracket when they retire, a Roth IRA may be a better choice for you. The downside is that you’ll have to pay the taxes now, but they will likely be at a lower rate. This should result in your overall cost being lower than if you were to pay taxes on your withdrawals in retirement.
What if you think you’re headed down the more conventional path that leaves you in a lower tax bracket during retirement? In that case, a traditional IRA might be the best financial decision for your big picture as you’ll likely be paying taxes at a lower rate later, resulting in a lower overall cost than if you paid upfront today. Of course, unless you have a very accurate crystal ball, you’ll really just be making an educated guess during this part of the decision-making process.
Something else to think about is that Roth IRAs are ideal wealth-transfer vehicles. This is because they do not carry any RMDs, and beneficiaries won’t owe income tax on withdrawals. However, beneficiaries will be required to take distributions or roll the account into an IRA of their own.
Finally, if you qualify for both types of IRAs, you don’t necessarily have to decide. You can own and fund both a Roth IRA and a traditional IRA. Just be aware that your total deposits in all your accounts cannot exceed the overall IRA contribution limit for that tax year.
