An individual retirement account (IRA) is a savings tool that functions as a tax-advantaged container for investments (stocks, bonds, CDs, mutual funds, ETFs, and so forth). Its two main varieties, the Roth and traditional IRA, each comes with its own set of rules. As is true for any financial move you make, your choice of which account type best suits your unique situation should be well-informed, anticipating future ramifications. In this article we’ll discuss the key differences between Roth and traditional IRAs and weigh in on the implications they may have for you.
Eligibility – Income and Age
Anyone with earned income under the age of 70½ can contribute to a traditional IRA. Although Roth IRAs don’t impose age restrictions, they do have restrictions on income. For instance, to contribute to a Roth IRA in 2017, single tax filers are required to have a modified adjusted gross income (MAGI) of less than $133,000, $196,000 for married couples filing jointly, or $10,000 for married couples filing separately. There are Roth IRA income phase-outs as well, which gradually decrease the amount you can contribute, and are put into place when your MAGI is within a certain range of your income limit. (MAGI is your adjusted gross income [AGI] with the addition of deductions and nontaxable income, such as earnings from foreign investments.)
Traditional IRA contributions are tax deductible on both state and federal tax returns for the year the contribution is made, while withdrawals in retirement are taxed at ordinary income tax rates. Roth contributions, on the other hand, are not tax deductible, but as they grow in the account they are not taxed, contributions can be withdrawn at any time without being taxed a second time, and earnings on contributions can be withdrawn tax free so long as requirements have been met (more on that in the next section).
In the case of traditional IRAs, taxable withdrawals of a certain percentage of funds, called required minimum distributions (RMDs), must be taken by April 1st of the year subsequent to the year you reach the age of 70½. Roth IRAs don’t require withdrawals at any point.
Both traditional and Roth IRAs permit withdrawals without charging an early 10% withdrawal penalty at age 59½, which would be on earnings in the case of Roth IRAs. (Both Roth and traditional IRAs also have exceptions to the early withdrawal penalty, which I won’t go into here.) As for whether payment of taxes is due on distributions, traditional IRA withdrawals of both contributions and earnings count as taxable income at any age. But withdrawals of earnings from Roth IRAs do not count as taxable income so long as they meet the requirements for qualified distributions. To be considered qualified, the first contribution must have been made at least five years before the first withdrawal, along with meeting at least one additional requirement: being age 59½, using it for a first-time home purchase, or being either dead or disabled.
The ability to take out contributions made to Roth IRAs at any time without penalty, their lack of required minimum distributions at 70½, and the fact you can keep investing in them after reaching that age make them a more flexible option than traditional IRAs. If you decide to leave your account to an heir or heirs, the RMDs could be a problem. There is a way around that problem through a Roth IRA conversion, although income taxes will generally become due on previously untaxed contributions in the account at that time. The inability to take contributions from traditional IRAs shouldn’t be that big a deal if you have a solid emergency fund, though.
But, to recap, if your MAGI is greater than $133,000 per year as a single filer, $196,000 if married and filing jointly, or $10,000 if married and filing separately, you won’t even have the option of investing in a Roth IRA.
On the basis of the account types’ differences in terms of tax benefits, one could conclude that Roth IRAs are a better option for those who expect to be in a higher tax bracket when they intend to start making withdrawals, with the opposite being true for traditional IRAs.
For those in a high tax bracket, a traditional IRA may make more sense. One, if you invest your savings from the annual tax deduction, it would allow you to keep and invest more money now. Two, in retirement or semi-retirement your tax bracket may be lower, with decreased monthly expenses due to owning a home that’s paid off, being free of debt, having self-sufficient children (though you may instead be burdened with the care of aging parents), fewer or no work-related costs (such as commuting)—meaning not having to work as many hours, thus less income and, accordingly, a lower tax bracket.
If your income falls within the acceptable limits, and if you’re currently in a low income tax bracket, I endorse investing using a Roth IRA over a traditional IRA.
If you’re in a high tax bracket, I’d say a traditional IRA is probably a better option, assuming that if retirement is a long way off, you’re investing the additional amount of income you’re able to keep due to the annual tax deduction for contributions.
There isn’t a clear-cut answer, as it’s dependent on unknown future variables such as whether the government changes tax brackets, whether you work during your retirement-age years, and if you do, how much you’re earning.
If you’re torn between the two, you can invest in both a Roth and traditional IRA, so long as you keep it under the maximum of $5,500 ($6,500 for those 50 and up) in 2017 for both (not per) account types.
Don’t agonize too much over the choice; both are good options. Focus on maxing out your annual contributions once you have a solid emergency fund (see Emergency Fund 101) in place and higher-interest debts paid off (see Should You Invest or Pay off Debt?) in order to minimize your chances of needing to withdraw from retirement accounts.