Saving for retirement is crucial, but what’s better: the traditional or Roth IRA?
IRAs, or Individual Retirement Accounts, provide tax-advantaged savings for retirement. If you don’t get a 401K through your employer or you have more money to save for retirement, you can open your own retirement account.
There are two basic IRA types to consider – the traditional and Roth IRA.
What is a Traditional IRA?
The traditional IRA offers upfront tax deductions, meaning any contributions will increase your tax deductions for the year during which they contribution is made. You can contribute up to $6,000 if you are under 50 years old, or up to $7,000 if you are over 50 years old. The money invested grows tax-deferred – you will have to pay taxes when you withdraw the funds after age 59 ½.
Benefits of the Traditional IRA
- Contributions will reduce your taxable income in the year that you make them. This may make you eligible for other tax incentives by lowering your adjusted gross income.
- Anyone younger than 70 ½ years old can contribute to a traditional IRA up to the above limits.
- There are no eligibility restrictions based on your income level.
- You may pay less tax when you withdraw the funds if you are in a lower tax bracket, which is often the case during retirement.
Disadvantages of the Traditional IRA
- If you take distributions before retirement, you will pay a 10% early withdrawal penalty (except in extreme circumstances).
- You must take required minimum distributions at age 70 ½ whether you need them or not.
What is a Roth IRA?
The Roth IRA is similar to a traditional IRA with a few differences. It doesn’t offer upfront tax deductions, you invest the money after you’ve paid taxes – but when you withdraw the funds in retirement, you don’t pay any taxes. It has the same contribution limits of $6,000 or $7,000 if you are over 50 years old, but there are income restrictions that limit your eligibility to participate if you have a high income level.
Benefits of the Roth IRA
- You don’t have to take mandatory withdrawals at age 70 ½ or any age.
- You can withdraw funds less than or equal to your Roth IRA contributions even before retirement age
- You can continue to make contributions past age 70 ½ as long as your income qualifies.
- The tax-free withdrawals help you manage your tax liability during retirement.
- Qualified withdrawals during retirement do not count towards your provisional income, which can impact the taxes you pay on any social security income.
Disadvantages of the Roth IRA
- Your income determines your eligibility to contribute to a Roth IRA. If you are single and have a modified adjusted gross income higher than $137,000 or married filing joint with a Modified Adjusted Gross Income (MAGI) higher than $203,000, you aren’t eligible.
- You pay taxes upfront which means you don’t get the instant tax incentive to save for retirement.
Choosing between the two IRA types is a personal decision. You are free to contribute to both, but the maximum contribution limits apply as a total, not per account. You can also contribute to both in addition to your 401K at work, which has its own limits ($19,500 if you are younger than 50 years old. If you have a tax-deferred 401K, the Roth IRA helps offset your tax liability in retirement by saving money after taxes. Because it’s impossible to predict your tax bracket upon retirement, diversifying your retirement funds may help alleviate the tax burden.