Traditional and Roth IRAs are both great options for retirement savings. But which one should you choose? Deciding on one or the other can certainly be confusing. And mistakes can cost a fortune in retirement!
The traditional IRA was created in 1974 and was first used a year later. The Roth IRA got created as a part of the Taxpayer Relief Act in 1997 thanks to Sen. William Roth. The biggest difference between a Roth IRA and a traditional IRA is how and when you get a tax break. A Roth IRA allows you to make after-tax contributions.
“If you think you’ll be in a higher tax bracket when you retire than you are now, then the Roth IRA might be a better option since you won’t have to pay taxes on the withdrawals,” says personal finance expert Kelan Kline. “But if you expect to be in a lower tax bracket when you retire, then the traditional IRA might make more sense because your contributions will be tax-deductible,” adds Kline.
While these accounts are comparable in many respects, they differ in several important ways, particularly with respect to their tax advantages. This article will help uncover the differences between both types of IRAs so that you can make an informed decision about which one is right for you!
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What is a traditional IRA?
A traditional IRA is a retirement savings plan that offers tax-deferred savings until withdrawn in retirement. The IRS does not assess capital gains or dividend income taxes in a traditional IRA. And withdrawals or distributions get taxed as regular income in retirement.
Those who work and are 49 and under can contribute up to $6,000 to a traditional IRA in 2022. And those 50 and over can contribute an extra $1,000 as a “catch up” contribution. These contributions may be tax deductible and reduce your income if you don’t already contribute to an employer-sponsored retirement plan, such as a 401(k).
Taxpayers can fund their IRA up to a specific dollar amount each and every year. However, if you intend to contribute, don’t miss the deadline (it’s the same as the federal tax filing deadline) because you’ll lose the contribution room. And if you over contribute, you may be assessed a penalty.
Be aware that there may also be income thresholds. Depending on if you contribute to an employer-sponsored retirement plan, your income and other factors, contributions to a traditional IRA may or may not be tax-deductible.
What is a Roth IRA?
A Roth IRA is a retirement account that is funded with after-tax money, and earnings growth and withdrawals are tax-free in retirement. It means that when you withdraw money from a Roth IRA, you won’t have to pay income taxes on any amount withdrawn if certain conditions are met.
Like the traditional IRA, those who work and are 49 and under can contribute up to $6,000 to a traditional IRA in 2022. And those 50 and over can contribute an extra $1,000 as a “catch up” contribution. However, unlike a traditional IRA, Roth IRA contributions are not tax-deductible and do not reduce your income.
The Roth IRA favorite among savvy investors because withdrawals in retirement are tax-free. This specific feature makes it my favorite retirement account, after a 401(k) with an employer match.
Contributions: Order of operations
Investments grow tax-free in Roth accounts. And distributions are also generally tax-free in retirement. Savvy investors will quickly realize the benefits of maxing out both Roth accounts first. For those who aren’t lucky enough to have an employer match with a 401(k), the Roth IRA should be the first account to get funded for retirement.
Once the Roth IRA is fully funded for the tax year, you should consider maxing out your Roth 401(k), if you have one. If you don’t have a Roth 401(k), next would be your IRA — or 401(k) if you have one. And if you’re fortunate enough to have money left over in your budget following your IRA and 401(k) contributions, the excess can get used to fund any other taxable brokerage accounts.
What if I need the money sooner than retirement?
Withdrawals in either a traditional or Roth IRA before age 59 ½ are usually subject to a 10% penalty, and the amounts are added to your income (Read: Don’t do it). However, there may be a time you need the money sooner. For example, if you want to buy a home, you can withdraw up to $10,000 penalty-free from a Roth IRA, if you’ve had the account for more than five years. And while early withdrawals from a traditional IRA for the same purpose will be taxed as income, you won’t be subject to a penalty if the funds are used within 120 days of the withdrawal.
Read more: 9 Penalty-free reasons for IRA withdrawals
Saving for retirement is a critical step in securing one’s financial future. But to get the maximum benefit, be sure to max out the limits and contribute in the right order.
Rick Orford is a Wall Street Journal, USA Today, and Amazon best-selling author, investor, and mentor. He’s appeared on Good Morning America and has been featured in the Washington Post, Yahoo Finance, MSN, Insider, and more. His passion is personal finance, and he works tirelessly to deliver content in an easy-to-understand manner.
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