The traditional IRA
The flagship feature of a traditional IRA is the ability to contribute “pretax” income and allow it to grow tax-free until you retire.
Depending on your income level, you can deduct the money you put into a traditional IRA from your income on both state and federal tax returns for that year. In doing so, you’ll reduce the amount of tax you owe and may even get a refund.
While it’s in the account, your money grows tax free, accruing compound interest — meaning the returns on your investments also earn returns. The effect can be enormous over a long span of time.
Many types of investments are OK inside an IRA, including stocks, bonds, ETFs and mutual funds. The gains in the value of those investments will be tax free, too.
You can begin making penalty-free withdrawals once you reach age 59 ½. Since you didn’t pay tax on your money earlier, your withdrawals are now taxed as income.
So what’s the point of pushing it off?
Well, you’re likely to find yourself in a much lower tax bracket once you’re no longer working. So you’ll pay less tax on the money you earned back when you were young.
It’s a great deal, but the amount you can contribute each year is limited. For 2020, you can contribute up to $6,000 if you’re under age 50, or $7,000 if you’re age 50 or older. The limits are unchanged from 2019.
The Roth IRA
The Roth IRA functions a lot like a traditional IRA, but with the tax situation reversed.
Instead of pretax income, you contribute “post-tax” income to your investment account. That means you pay income tax upfront on the money you contribute each year.
As such, your contributions are not tax deductible.
However, when you eventually start taking money out in retirement, your withdrawals are tax free, and that includes earnings you withdraw. You've already paid the taxes.
Many other traditional IRA traits are the same for a Roth. You can store all kinds of investments. And the contribution limits for Roth IRAs are currently the same: You can contribute up to $6,000 if you’re under age 50, or $7,000 if you’re age 50 or older.
But it’s important to know that the pretax and post-tax question isn’t the only divide.
Other key differences
Required minimum distributions
With a traditional IRA, you can’t stow your money away indefinitely.
You have to start making minimum withdrawals (known as “required minimum distributions”) once you turn 72. If you don’t, the Internal Revenue Service will take a savage 50% of what you were supposed to withdraw. But note that this rule has been suspended for 2020 because of the coronavirus crisis.
With the Roth IRA, there are no required minimum distributions. You can leave your money stored in your Roth IRA for as long as you want.
In fact, you can leave the money in there until you die and bequeath your Roth IRA to an heir or beneficiary.
The IRS is pretty stringent about early withdrawals from a traditional IRA. If you withdraw money from your traditional IRA before age 59 ½, you’ll pay taxes on it and a 10% early withdrawal penalty.
You can avoid the penalty (but not taxes) in some special circumstances. For example, you can use up to $10,000 on your first home. There are different exceptions for things like college expenses, medical bills or the birth of a child.
If you park your money in a traditional IRA, expect to leave it there for a long, long time.
The Roth IRA definitely wins for flexibility and leniency with early withdrawals. You can move the money you put into your Roth IRA out without any fees or penalties.
However, the rules are different when it comes to your Roth IRA earnings. Your earnings are any sums of money above the amount you contributed that year, such as interest or dividends.
With few exceptions, anyone who withdraws their earnings before age 59 ½ will pay income tax and a 10% penalty.
Income and age restrictions
Anyone with an income can set up and contribute to a traditional IRA, and there's no minimum amount for opening one.
Whether or not you qualify for a tax deduction depends on a couple factors. If you don’t have a retirement plan through your work, no problem: You can fully deduct your contributions, as long as they're within the annual limit. If you do have a retirement plan through work, or your spouse does, then the amount you can deduct depends on your income.
That amount could be zero: For example, a single person earning more than $75,000 in 2020 can’t deduct anything at all.
Roth IRAs have no age restrictions but they do have income limitations. If you make too much money, you won’t be eligible to set up a Roth IRA.
For single people, your income cannot exceed $139,000 in 2020. For married couples, your income cannot exceed $206,000.
How to decide
First, let’s review the similarities and differences between these accounts:
|Roth IRA||Traditional IRA|
|Age requirements||Can contribute at any age.||Can contribute at any age.|
|Income requirements||Your income affects the amount you can contribute.||There are no income limits.|
|Tax incentives||Growth and qualified withdrawals are tax-free.||Contributions are tax-deductible, and growth is tax-deferred.|
|Withdrawal taxes||Earnings are tax-free if withdrawn at age 59 ½ or later. And, the account must be at least 5 years old.||Both contributions and earnings are taxed when they’re withdrawn.|
|Early withdrawal penalties||Earnings are subject to a 10% penalty if withdrawn before age 59 ½.||All withdrawals are subject to a 10% penalty before age 59 ½.|
|Required minimum distributions (RMDs)||These mandatory withdrawals are required only after the passing of the account owner.||Suspended for 2020. Then, RMDs must be taken starting in the year you turn 72.|
One of the most important questions to ask yourself is: What will my income (and tax bracket) look like when I eventually retire?
It seems counterintuitive, but your taxable income can actually go up after you retire.
You may have to pay taxes on sources of fixed income, like Social Security benefits. You may have income from other investments. You might do some freelance or consulting work. And you’ll lose critical tax deductions once you have fewer dependents.
So if you think you’ll be in a higher income-tax bracket come retirement, consider the Roth IRA. You’ll pay taxes now, but your withdrawals will be tax free during your retirement. You’ll also have more freedom to withdraw money before retirement if you desperately need it.
If you think you’ll be in a lower tax bracket, it might make more sense to go with the traditional IRA. You’ll get tax benefits now and pay taxes at a lower rate later on.
Or if you want to split the difference, you can contribute to both a traditional IRA and a Roth IRA at the same time. Just know that your total contributions cannot exceed the limits for that year.
Now, if you’re having trouble sorting all of this out, it doesn’t hurt to ask for expert advice.
A certified financial planner can take a look at your particular situation, lay out your options and help you chart a course to a happy retirement. The advisers at Facet Wealth are available online and are bound by law to put your interests first.
Remember, you don’t need to have all the answers right now. Whichever account you pick, the most important thing is just getting started.