When planning for retirement, choosing the right Individual Retirement Account (IRA) is crucial. The two most popular options are the Traditional IRA and the Roth IRA. Each has its own set of benefits and tax implications, making the decision dependent on your financial situation and future outlook. Here’s a closer look at each type to help you decide which might be better for you.
Traditional IRA
Contributions and Tax Benefits:
- Tax-Deferred Growth: Contributions to a Traditional IRA are typically tax-deductible in the year they are made. This means you won’t pay taxes on the contributions until you withdraw them in retirement.
- Immediate Tax Break: If you expect to be in a lower tax bracket in retirement, a Traditional IRA can provide significant tax savings during your high-earning years.
Withdrawals and Taxability:
- Taxable Withdrawals: When you start taking distributions in retirement, the withdrawals are taxed as ordinary income.
- Required Minimum Distributions (RMDs): Starting at age 73, you must begin taking RMDs, regardless of whether you need the funds.
Roth IRA
Contributions and Tax Benefits:
- After-Tax Contributions: Contributions to a Roth IRA are made with after-tax dollars. This means you won’t get a tax break in the year you make the contribution.
- Tax-Free Growth: The major advantage is that both your contributions and earnings grow tax-free. Withdrawals in retirement are also tax-free, provided certain conditions are met.
Withdrawals and Taxability:
- Tax-Free Withdrawals: Qualified distributions (those taken after age 59½ and the account has been open for at least five years) are completely tax-free.
- No RMDs: Roth IRAs do not have required minimum distributions, allowing your savings to grow tax-free for as long as you choose.
Which is Better for You?
Consider a Traditional IRA if:
- You expect to be in a lower tax bracket in retirement.
- You want a tax deduction now to reduce your taxable income.
- You prefer to defer taxes until you start withdrawing the money.
Consider a Roth IRA if:
- You expect to be in the same or higher tax bracket in retirement.
- You prefer tax-free withdrawals and are willing to forego the immediate tax benefit.
- You want flexibility with no RMDs, allowing you to let your investments grow tax-free for a longer period.
Traditional IRA vs Roth IRA Comparison Chart
|
Roth IRA |
Traditional IRA |
|
|
Annual contribution limit |
$7,000 in 2024 ($8,000 if age 50 and older). The contribution limit for IRAs is a combined limit. |
$7,000 in 2024 ($8,000 if age 50 and older). The contribution limit for IRAs is a combined limit. |
|
Income |
Ability to contribute is phased out at higher incomes. |
Ability to deduct contributions can be phased out depending on income and access to an employer retirement plan. |
|
Tax benefits |
No immediate tax benefit for contributing; distributions in retirement are tax-free. |
If deductible, contributions reduce taxable income in the year they are made. Distributions in retirement are taxed as ordinary income. |
|
Early withdrawal options |
Roth IRAs allow contributions to be withdrawn at any time, but earnings distributed before age 59 1/2 may be subject to a 10% penalty and income taxes, unless you meet an exception. There is also a five-year holding rule for Roth IRA investment earnings. |
Unless you meet an exception, distributions from a traditional IRA before age 59 1/2 are subject to taxes and a 10% penalty. This applies to both contributions and investment earnings. |
|
Distributions in retirement |
No required minimum distributions. |
There are required minimum distributions once you reach a certain age. That age was previously 72; in 2023, it increased to 73 and in 2033, it will increase again to 75. |
Choosing between a Traditional IRA and a Roth IRA depends on your current financial situation, future income expectations, and retirement goals. It may also be beneficial to consult with a financial advisor to tailor the decision to your specific needs. By understanding the tax implications and benefits of each, you can make an informed choice that aligns with your long-term financial strategy.
*Use the Charles Schwab Roth vs. Traditional IRA calculator.