I regularly receive reader questions asking me to clarify the difference between a Roth IRA and Traditional IRA plan. Both are excellent retirement investment vehicles, but based on your income and tax situation one may be a better first choice than the other. Here are some key differences and a summary table of the two retirement investment options for easy reference. At the end of the article are the article are links to more resources and annual updates. You can see this article for a step-by-step walk through of choosing the best retirement plan for you.
A Traditional IRA offers a tax-deferred retirement investment option, with investors being able to deduct all or part of their contributions from pretax income if certain conditions are met. This also makes it an effective way to reduce current tax obligations – particularly for those in higher income tax brackets.
There are no income limitations on being able to contribute to a Traditional IRA, but you must be under age 70½ and have earned income. You must also have earned income equal to or greater than your contributions.
You generally pay taxes when you make withdrawals, at which time you may be in a lower tax bracket. If you withdraw before the official retirement age (59 ½), you will also have to pay additional penalties unless you can prove extenuating circumstances (like spouse death, hardship, disability and qualified medical expenses).
All withdrawals from a Traditional IRA (except for amounts attributable to nondeductible contributions) are generally taxed as ordinary income – a key difference to Roth IRA’s. You must begin taking required minimum distributions by April 1 of the year following the year in which you reach age 70½.
You’re eligible for a fully deductible IRA contribution if neither you nor your spouse participates in an employer-sponsored (401K) retirement plan. If either of you do participate in such a plan, your ability to deduct your full IRA contribution may be limited by your income.
A Roth IRA, like a traditional IRA, is a tax effective/differed retirement savings plan. Unlike the traditional IRA though, once you reach age 59½, you may qualify for tax-free withdrawals of both contributions and any accumulated earnings. In addition, you’re never required to take distributions, making a Roth IRA an effective option for both retirement and estate planning purposes.
Further, you may realize tax savings if you think your tax bracket in retirement will be higher than your current rate. A five-year holding period required for tax-free withdrawals regardless of investor’s age.The Roth IRA is subject to penalties if withdrawn early, but up to $10,000 in earnings may be withdrawn tax-free if used for a qualified first-time home purchase.
The Roth IRA is also an effective inheritance vehicle because you may potentially reduce or eliminate the taxes your beneficiaries will have to pay after inheriting. You may be able to contribute to a Roth IRA for yourself or your spouse if you have earned income.
The IRS releases 401K and IRA Limits on an annual basis that are updated based on cost of living adjustments (COLA). The main impact to IRA and Roth IRA plans are the income eligibility/phase-out limits. You can click the links below to see the latest annual limits or go to the 401k/IRA resource page.