Retirement: What are the 10 differences between a traditional and Roth IRA?

 

Retirement:

What are the 10 differences between a traditional and Roth IRA?

1. Contribution Tax Treatment

Traditional IRA: Contributions are typically made with pre-tax dollars, which means they may be tax-deductible, reducing your taxable income for the year. Taxes are paid when you withdraw the funds during retirement.

Roth IRA: Contributions are made with after-tax dollars, meaning you pay taxes on the money before contributing. Qualified withdrawals, including earnings, are tax-free.

2. Tax Treatment on Withdrawals

Traditional IRA: Withdrawals are taxed as ordinary income during retirement. This means you will pay taxes on both contributions and earnings when you take distributions.

Roth IRA: Withdrawals are tax-free if certain conditions are met, including being 59½ or older and having held the account for at least five years. This applies to both contributions and earnings.

3. Income Limits for Contributions

Traditional IRA: There are no income limits for making contributions, but the ability to deduct contributions from your taxable income may be limited based on your income and participation in other retirement plans.

Roth IRA: Contributions are subject to income limits. If your income exceeds certain thresholds, you may not be eligible to contribute directly to a Roth IRA.

4. Deductibility of Contributions

Traditional IRA: Contributions may be tax-deductible depending on your income level and whether you or your spouse are covered by a workplace retirement plan. The deductibility phases out at higher income levels.

Roth IRA: Contributions are not tax-deductible. You pay taxes on the money before contributing to the Roth IRA.

5. Required Minimum Distributions (RMDs)

Traditional IRA: You are required to start taking RMDs at age 73 (as of 2024). These distributions are subject to ordinary income tax.

Roth IRA: Roth IRAs do not have RMDs during the account owner's lifetime, allowing the funds to grow tax-free for as long as you like.

6. Contribution Limits

Traditional IRA and Roth IRA: Both have the same annual contribution limits. For 2023, you can contribute up to $6,500, or $7,500 if you are 50 or older.

7. Early Withdrawal Rules

Traditional IRA: Withdrawals before age 59½ are generally subject to a 10% penalty, in addition to ordinary income taxes, unless an exception applies (e.g., first-time home purchase, qualified education expenses).

Roth IRA: Contributions (but not earnings) can be withdrawn at any time without penalties or taxes. Earnings may be subject to penalties and taxes if withdrawn before age 59½ or before the account has been open for five years, unless an exception applies.

8. Impact on Taxes

Traditional IRA: Contributions may reduce your taxable income in the year they are made, potentially lowering your current tax bill. The benefit is realized in the current year.

Roth IRA: Contributions do not affect your current tax bill, as they are made with after-tax dollars. The benefit is realized in retirement with tax-free withdrawals.

9. Eligibility for Contributions

Traditional IRA: You can contribute regardless of your income level, though the tax deductibility may be limited based on income and whether you participate in an employer-sponsored retirement plan.

Roth IRA: Eligibility to contribute is limited by income. For 2023, single filers with a modified adjusted gross income (MAGI) above $153,000 and married couples above $228,000 are phased out from contributing directly.

10. Flexibility in Retirement Planning

Traditional IRA: The tax benefits are realized now, but taxes are owed on withdrawals during retirement. This may be advantageous if you expect to be in a lower tax bracket in retirement.

Roth IRA: Provides tax-free withdrawals and no RMDs, which can be advantageous if you expect to be in the same or a higher tax bracket in retirement. The flexibility to leave money in the account indefinitely allows for strategic estate planning.