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Amongst the tax-advantaged investment accounts available to you, IRAs are one of our favorites. Unlike 401(k) accounts, IRAs allow you to choose any stock, bond, mutual fund, REIT, ETF, etc. that you want. This flexibility can provide significantly more choice in your investments. However, you’ll need to open up an IRA account to get these advantages. You will have to choose if you want to open a Roth IRA or a Traditional IRA. For those of you wondering about the differences of a Roth vs Traditional IRA, this article is for you.
What is an IRA?
Before we talk about the differences between a Roth and Traditional IRA, let’s lay the groundwork of what an IRA is and whether it makes sense to use for your portfolio.
An IRA, or Individual Retirement Arrangement, is essentially just a brokerage account that offers tax advantages.
Roth IRAs offer tax advantages by allowing you to pay tax on your contributions now. Traditional IRAs allow your earnings to grow tax-deferred until retirement, at which point you pay taxes on your withdrawals.
Both types of IRAs allow you to contribute up to $6,000 per year at present, or $7,000 per year if you are age 50 or older. Note that your taxable income is the max you can contribute if your income is less than the contribution cap (e.g., if you earn $3,000/yr., your contribution limit is $3,000).
If you have the choice, we’d recommend maxing out your IRA before your 401(k) at work. The selection of funds you can choose for your portfolio is much greater. More fund selection can help you diversify and reduce risk. Just remember to make sure to at least max out your company match in your 401(k). Once you do this, and aim to max out your 401(k) after you max out your IRA.
Before you consider investing in an IRA, make sure you pay down high-interest-rate debt and build an emergency fund. Check out our guide on Where to Save & Invest First.
While both types of IRAs offer tax advantages, both varieties also come with some significant restrictions. We’ll cover some of these restrictions as we lay out what makes the Roth and Traditional IRAs different from each other.
What makes a Roth IRA different?
A Roth IRA allows you to contribute after-tax dollars to your IRA account. In practice, this means that you pay tax now on your contributions.
Once you pay tax, your account grows 100% tax-free. You’ll never pay tax again on your contributions or your earnings growth. Ever. One and done from a tax perspective.
We love this feature. It simplifies your tax planning, such that you know whatever money in your account is yours to keep.
However, there is an income restriction on contributing to an IRA. If you’re single and your modified adjusted gross income (MAGI) is less than $125,000, you can contribute up to the maximum amount of $6,000. The income restriction then scales down as your MAGI grows up to $140,000. At or above $140,000, you can no longer contribute to a Roth IRA.
For married couples filing jointly, these numbers are $198,000 and $208,000, respectively. Note that all of these figures are as of 2021 and do change year-to-year.
If you’re in the “scale down” range, check the IRS website for details about your contribution limit.
If you are over the income limit, there is one tactic in use to contribute to a Roth IRA, called the Backdoor Roth IRA. The concept is that you open a Traditional IRA, add after-tax funds, then convert those funds into a Roth IRA. It is worth noting that the IRS has never provided formal guidance on whether this is permissible, so it is not entirely without risk. Check out this great article from Schwab on what the Backdoor Roth is and whether it is right for you. However, we urge you to discuss this strategy with your tax professional.
Another benefit of the Roth IRA is that there are no required minimum distributions. What this means is that you do not have to withdraw funds at any age.
One last benefit of the Roth IRA is that it allows you to withdraw your contributions penalty-free. If you contributed $6,000 and your account balance is now $6,500, you can take out the $6,000 at any age with no penalties.
You cannot, however, withdraw earnings until you are at least 59 1/2 without paying penalties.
Your Roth IRA must also be five years old to take withdrawals.
Lastly, there are exceptions to the early withdrawal penalties for cases like a first-time home purchase, college expenses, and birth/adoption expenses. Be sure to speak to a tax professional before you take any withdrawals to make sure you avoid tax implications. Schwab also offers a useful guide on these restrictions.
What makes a Traditional IRA different?
With the traditional IRA, you typically receive a tax deduction now on the contributions that you make. Your contributions then grow tax-deferred until retirement, at which point you will pay tax on withdrawals at your then-current marginal tax rate.
You get to put in before-tax money that then grows until retirement.
However, it is essential to understand that not all contributions are tax-deductible. There are restrictions here as well.
If a retirement plan covers you at work (such as a Roth or traditional 401(k)), your tax deduction is restricted. If your employer offers a retirement plan, you are single, and you have a modified adjusted gross income of $65,000 or less, you can deduct the full amount of your contribution. The deduction limit then scales down up to an adjusted gross income of $75,000, after which point you receive no deduction. The same is true for married couples, at $104,000 and $124,000 of modified adjusted gross income, respectively.
If a retirement plan at work covers neither you nor your spouse, there is no income limit on deducting your IRA contribution. If you file jointly and your spouse’s employer offers a retirement plan, you can deduct the full amount if your income is $196,000 or less, with a scale-down up to $206,000 in modified adjusted gross income.
With the Traditional IRA, you must begin taking distributions from your account once you hit age 72. Why is this the case with the Traditional but not the Roth? Uncle Sam wants to collect his tax revenue, as he’s given you the privilege of deferring it for many years.
However, unlike a Roth IRA, withdrawals on contributions are subject to a penalty (depending on age), except when used for specific purposes.
Roth vs Traditional IRA: Which is best for you?
Choosing a Roth vs. Traditional IRA is primarily based on your future tax expectations. If you believe that your tax rate will be higher in retirement than it is today, you’re better off with the Roth IRA. If, however, you think you will be in a lower tax bracket at retirement, then you’re better off going with the traditional IRA.
The problem is, predicting your tax rate is difficult. It’s not just a matter of figuring out if your income will be higher or lower in retirement, but you must consider the actions of the politicians and whether you think tax rates will be more or less in the future.
For most people, we think the Roth IRA can make a lot of sense. Why? Because the Roth IRA:
- Simplifies tax planning
- Has more flexible early withdrawals (you can withdraw contributions if you need the money)
- Carries no required minimum distributions
The only real advantage of the Traditional IRA is the upfront tax break, and that benefit phases out at a moderate-income level. Unless you’re relatively sure that your tax rate will be lower in retirement, be sure to think through selecting the Traditional IRA.
If you’re not eligible for the tax deduction because of your income/retirement account options at work, don’t bother with the Traditional IRA.
If you’re above the contribution limit for the Roth IRA, look into a Roth conversion to see if that strategy might work for you.
When comparing the Roth vs. Traditional IRA, both products offer some remarkable tax advantages, and we prefer them to the 401(k), assuming you’ve maxed your company match.
For most folks, we think the Roth IRA can be a solid choice because of the additional flexibility it offers, but if you think your tax rate will be lower in retirement than it is today, go for the traditional IRA.
Note that all of the above contribution limits, income limits, and age restrictions are as of 2021. Be sure to check what the latest restrictions are before contributing to an IRA. The IRS website is a tremendous resource to figure out what you can or cannot do with your IRA.
Which type of IRA do you prefer? Let us know in the comments below!