Traditional IRA vs Roth IRA : If you’re contemplating funding an Individual Retirement Account (IRA) to build your nest egg, you’re probably wondering which type of account would be better for you: Traditional IRA or Roth IRA? On the surface, they both look pretty similar, but there are some very significant differences.
Here are some key differences between traditional ira vs roth ira and similarities between both types of IRA accounts that you should consider while making a decision:
The limitation on contribution age is one of the key deciding factors for most people, since:
- You cannot make participant contributions towards traditional IRAs for the year you cross 70 ½ years of age and after.
- There is no age limit for contributions towards Roth IRAs, as long as you have earned income within the income limitations.
Income limitations are imposed based on your Modified Adjusted Gross Income (AGI). You can calculate your AGI using Publication 590’s Worksheet 2-1.
The only limitation of a traditional IRA is that you must have earned income, which includes tips, commissions, bonuses, self-employment income and many more sources.
Depending on your filing status and AGI for the year, you may have to start phasing out contributions, or be altogether ineligible for Roth IRA contributions.
- Married filing Separately– $5,500 without no income, reduced from $1 to $9,999 and ineligible for $10,000 and greater.
- Married filing Jointly– $5,500 up till $189,000, reduced from $189,001 to $199,000 and ineligible for $199,001 and greater.
- Single- $5,500 up till $120,000, reduced from $120,001 to $135,000 and ineligible for $135,001 and greater.
Both traditional and Roth IRAs provide tax-linked benefits. The difference lies in when they’ll affect you:
- Contributions towards a traditional IRA are tax-deductible for the same year, on federal and state tax returns, depending on the income amount, tax-filing and active-participant status.
- Roth IRAs don’t offer any tax-breaks for contributions, but any income earned by your investments is tax-free.
Taxes on the withdrawals and earnings for both types of IRA accounts are calculated differently:
- Withdrawals from a traditional IRA are taxable when distributed, though this could benefit you in the future when you’re likely to be in a lower tax-bracket.
- Withdrawals and earnings from a Roth IRA are tax free, though there is a five-year ‘aging’ period.
Early withdrawals and non-qualified distributions may attract penalties and additional taxes:
- If you start withdrawing from a traditional IRA before you’ve crossed 59 ½ years of age, there may be a 10% early withdrawal penalty, unless an exception applies.
- Except when an exception applies, non-qualified distributions from Roth IRAs will be taxed as earned income and an additional 10% tax.
A major difference between Roth and traditional IRAs is when you have to start making withdrawals:
- While withdrawals from both types of accounts are penalty-free after you’re 59 ½ years old, traditional IRA holders have to start taking minimum required distributions when they are 70 ½ old.
- Roth IRAs have no MRD, so your investments can keep growing tax-free for as long as you live, and beneficiaries won’t owe income tax on the withdrawals, except perhaps estate taxes.
The contribution limits for both types of IRA accounts for the years 2017 and 2018 are the same:
- The maximum contribution limit for traditional and Roth IRAs is $5,500. Additionally, your combined contributions to both IRAs cannot exceed $5,500. If you contributed $2,000 to a traditional IRA, you cannot contribute more than $3,500 towards a Roth IRA.
- Neither of the accounts allow you to contribute more than 100% of your employment compensation. So, if your income was $3,000 for 2017, you cannot contribute more than $3,000 for the year.
Participants who are 50 years old or over can contribute an additional ‘Catch-up’ amount:
- The catch-up contribution is limited to $1,000 for both Roth and traditional IRAs.
- Along with the regular contribution limits, this means you can contribute up to $6,500 in 2018 and bump-up your investments.
The last date for contributions for the 2017 tax year is the same for Roth and traditional IRAs – Tuesday, the 17th of April 2018. For the 2018 tax year, the last date for contributions is Monday, the 15th of April 2019.
Before you start writing out a check, it’s always a good idea to compare quotations and prices from different organizations.
- Check the minimum investment for opening an account and the minimum contributions you’ll have to make. Some companies may not charge you for rollovers and transfers, or if you set up automatic contributions.
- Compare the fees for setting up and maintaining the account, and take into account the trading fees for trading mutual funds. They may look insignificant, but they can add up quickly.
If you meet the eligibility criteria for both types of IRAs, you can split your investments, but this may not always benefit you:
- Since you can’t exceed $5,500 ($6,500 if you’re older than 50), you can contribute the amount that is deductible towards a traditional IRA, and the rest to a Roth.
- Before you decide to split your contributions, consider how the additional fees for maintaining two separate IRAs and trade-related fees will affect your investments
Since the contributions towards traditional and Roth IRAs are taxed differently, your earnings from the investments are also treated differently:
- Earnings from traditional IRA investments grow on a tax-deferred basis. Once you start taking distributions, they are added to the taxable income for that year.
- Roth IRA investment earnings grow tax-free. Qualified distributions, including distributions of the earnings are also tax-free.
The ‘Savers Tax Credit’ is available for lower income households and individuals who are contributing to Traditional and/or Roth IRAs.
Perhaps the most crucial factor to consider is future tax rates, and how they’ll affect your investments, but they’re difficult to predict. Take a step back, assess your current financial scenario and ask yourself a few basic questions:
- Which Federal and State Tax bracket are you in today, and which bracket will you be in when you
start making withdrawals?
- Is your income, including Social Security, likely to increase or decrease after you retire?
- Given that the current Federal tax rates are at a historical low and there’s a huge deficit, economists predict that tax rates in the future may increase. Would Roth IRAs benefit you more?
This decision should not be taken lightly, since it can impact the way your money is taxed, how much it grows, and eventually your retirement income!