You want to start an IRA–but should it be Roth or traditional? The two plans are very similar, but hardly identical. Which plan will be better for you will largely depend on your tax situation, both now and later when you reach retirement.
Traditional vs. Roth IRA – The Similarities
The two plans actually do have a lot in common. Let’s take a close look at those similarities.
Contribution limits. For 2019, IRS regulations allow you to make an annual contribution of $6,000 to either IRA. If you’re age 50 or older, there is a “catch-up contribution” of $1,000 per year. Your total contribution will be $7,000 per year.
Eligibility. The most basic requirement for an IRA contribution is earned income. It must be sufficient to cover the amount you’re contributing to the plan. Unearned income sources, like investment income, are not eligible funding sources. There are income limits restricting contributions to either plan, but we’ll get into those in some detail later.
However, there is one major difference worth noting. You are no longer eligible to make contributions to a traditional IRA once you turn 70 ½, even if you have earned income. But there is no age limit on Roth IRA contributions, as long as you have earned income.
Investment income is tax deferred. Both plans enable your investment earnings to accumulate on a tax deferred basis. That includes the Roth IRA, at least until you turn 59 ½, and the earnings can be withdrawn tax-free.
Nearly unlimited investment options. One of the most attractive features of an IRA account, Roth or Traditional, is that a self-directed plan can hold just about any type of investment, or be held with any trustee of your choice. The IRS does have a list of prohibited IRA investments, but they’re very unusual. Those include:
- Metals (with exceptions for certain kinds of bullion)
- Coins (but there are exceptions for certain coins)
- Alcoholic beverages
- Certain other tangible personal property
Early Withdrawal Rules – Similar, but Not Identical
This is where the two plans begin to separate. With either IRA, you are required to avoid making withdrawals prior to turning 59 1/2. If you withdraw before this, the distribution will be subject to both ordinary income tax and a 10% early withdrawal penalty. (The IRS does have a list of exceptions to the early withdrawal penalty, but not the ordinary income tax.)
But the rules are a little bit different with the Roth IRA. Since your contributions to the plan are not tax deductible, they can be withdrawn free from income tax. But any withdrawal of investment earnings will be subject to both ordinary income tax and the penalty. And under IRS ordering rules, contributions can be withdrawn from a Roth IRA first. You don’t need to make an allocation between contributions and investment earnings.
This also makes the Roth IRA the preferred plan if you think you’ll need to access the funds early for any reason.
Traditional vs. Roth IRA – The Differences
This is where the traditional and Roth IRAs begin to look like two very different plans.
Tax deductibility of contributions. Roth IRA contributions are never tax deductible. Traditional IRA contributions are usually deductible. (we’ll look at the exceptions below).
Taxability of withdrawals. Withdrawals made from a traditional IRA can be taken penalty free after age 59 ½, though they will be subject to ordinary income tax. If any contributions made to a traditional IRA were not tax deductible, they will not be taxable at withdrawal.
The non-deductible portion must be pro-rated. For example, if your traditional IRA has $250,000, and $25,000 is from non-deductible contributions, then 10% ($25,000 divided by $250,000) of any distributions taken will not be subject to tax. If you take a distribution of $1,000, $900 will be taxable, and $100 (10%) won’t be.
Withdrawals from a Roth IRA will be tax-free and penalty-free if taken after you turn 59 ½ and have participated in a Roth plan for at least five years. This is the main attraction of the Roth IRA.
Require minimum distributions (RMDs). All retirement plans are subject to RMDs, including the traditional IRA. RMDs are required to begin at age 70 ½ with distributions based on your life expectancy as of each subsequent age.
There are several distribution calculations available, but a typical RMD at 70 ½ is about 4%. On a $500,000 traditional IRA the distribution required would be about $20,000.
The Roth IRA is the one exception to the rule. No RMDs are required when you turn 70 ½ or any other age. You can allow the money to build up in your account for the rest of your life. This is why the Roth IRA is one of the best strategies to avoid outliving your money. You can make it the last account you withdraw from, and only after others have been exhausted.
Income Limits for Contributions
This is where the two plans are completely different. The IRS has income limits established for each plan. In the case of the Roth IRA, once you reach the income limit, you cannot make a contribution to the plan at all. With the traditional IRA, your tax deduction is limited or eliminated if you make over a certain amount of money and you’re covered by an employer plan.
Roth IRA income limits for contributions
The 2019 income limits for Roth contributions are as follows:
- Married filing jointly, allowed to $193,000, phased out to $203,000, then no contribution permitted.
- Married filing separately, phased out to $10,000, then no contribution permitted.
- Single, head of household, or married filing separately and you did not live with your spouse at any time during the year, allowed to $122,000, phased out to $137,000, then no contribution permitted.
Traditional IRA income limits for contributions
These limits are more complicated because there are two sets of numbers. One limits the deduction if you or you and your spouse are covered by an employer plan, and the other if one spouse is covered and the other isn’t. (There is no limit on income if neither you nor your spouse are covered at work.)
If you are covered by an employer plan, the income limits are as follows:
- Single or head of household, fully deductible up to $64,000, partially deductible to $74,000, then no deduction permitted.
- Married filing jointly or qualifying widower, fully deductible up to $103,000, partially deductible to $123,000, then no deduction permitted.
- Married filing separately, partially deductible up to $10,000, then no deduction permitted.IMPORTANT: Income is based on modified adjusted gross income, or MAGI, not necessarily the amount you earn.
The second set of limits applies if you aren’t covered by an employer plan, but your spouse is (once again, the income is based on MAGI).
Here are the limits for 2019:
- Married filing jointly, fully deductible up to $193,000, phased out up to $203,000, then no deduction permitted.
- Married filing separately, partial deduction up to $10,000, then no deduction permitted.
Please note that even if you exceed the income limits, you can still make a non-deductible traditional IRA contribution. But with a Roth IRA, no contribution is permitted at all if you exceed the income limits.
Traditional vs. Roth – Which IRA Will Work Best for You
It really comes down to your tax situation. The traditional IRA generally works better if you are currently in a high tax bracket and need the deduction, and expect to be in a lower tax bracket when you retire. The basic idea is to get the benefit of high tax savings now, in favor of a much lower tax liability later.
You will also want to take a non-deductible traditional IRA contribution if your income exceeds the threshold to make a Roth contribution.
The Roth IRA will be the better choice if you are currently in a relatively low tax bracket, but want to have tax free income in retirement. If you anticipate having several retirement income sources, this could be very important.
The combination of Social Security, a pension, investment income, and income from other retirement plans, could put you in a higher tax bracket in retirement than you are during your working years. The Roth IRA will enable you to take income tax free, or even to avoid withdrawals until very late in your life.
It’s worth noting that if you have a 401k and sign up to have it managed by blooom, the advisors of blooom may be able to offer advice on IRAs. However, blooom doesn’t actively manage IRAs, only 401k accounts. It’s worth looking into, especially if you’re stuck on what to do with your 401k. This way, you can have your 401k managed by blooom and also use their experts to give you general advice on your IRA.
Also, if you’re looking for a free tool to let you know if you’re on the right track to hit your retirement savings goal, you’ll want to sign up for Personal Capital. Their retirement calculator lets you run through several scenarios to help you figure out what you need to do to improve your retirement plan. Again, it’s free! So there’s not reason not to take advantage of this tool. You can read more about it in our review.
Now, back to IRAs. If you’re unsure which route to take, sit down with your accountant or tax preparer and crunch the numbers. More than anything, traditional vs. Roth is really a math equation. The answer is somewhere in the numbers.