Traditional IRA vs. Roth IRA: What’s the Difference?

Learn which one is right for your financial situation

A Rollover IRA is a type of individual retirement account into which an employee can transfer assets from another, previous retirement account or plan. For example, if you leave a job, in most circumstances, you can make a tax-free transfer of your 401(k) plan assets to a Rollover IRA at a brokerage firm or mutual fund company, severing ties with your old employer and giving you more control over where your capital is invested.
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From the time we start a first job as teenagers, many of us are told about the importance of putting a portion of every paycheck into a retirement account. One common way to save for retirement is through an employer-sponsored retirement plan. However, the Bureau of Labor Statistics found that in 2019, only 60% of U.S. workers had access to a defined contribution plan such as a 401(k) or 403(b).

That means many workers must rely on their own initiatives to save for retirement. A common means of doing so is creating an individual retirement account, also known as an IRA. There are numerous investing options within either type of IRA—being traditional IRAs and Roth IRAs—including individual stocks, bonds, mutual funds, exchange-traded funds (ETFs), and even real estate. If you determine that saving for retirement in an IRA makes sense, the next decision is whether to go with a traditional IRA or a Roth IRA.

While both types of IRAs are designed for long-term growth of savings through investments, each has key rules that result in important differences. This includes how your contributions are taxed and how much you can deposit into your IRA each year, plus when and whether funds must be withdrawn. It’s critical to understand these differences so you can choose the type of IRA that best suits your needs.

Understanding Traditional and Roth IRAs

Contributions to a traditional IRA may be tax-deductible at the time they are made. Income taxes are assessed when you begin to withdraw funds in retirement. For this reason, high-earners may prefer a traditional IRA over a Roth IRA because they reap the tax savings upfront and take the tax hit in retirement when they are often in a lower income tax bracket.

Contributions to a Roth IRA are made with after-tax dollars. A key benefit of a Roth IRA is that qualified distributions are tax-free. That means any growth of the funds in a Roth IRA will not be taxed, which is why they are such an attractive investment option for those who start saving early.

Feature Traditional IRA Roth IRA
Tax benefits Tax-deductible contributions and tax-deferred growth Tax-free growth potential and qualified withdrawals are tax-free
Age requirements Prior to 2020, individuals over 70½ could not make contributions. Under the SECURE Act of 2019, contributions are allowed at any age. Contributions are allowed at any age.
Income requirements Anyone over 18 with any amount of earned income can contribute. However, income limits may decrease or eliminate the amount that is tax-deductible. For tax year 2021, a single taxpayer with a modified adjusted gross income of $140,000 or more is not allowed to contribute. The limit is $208,000 for married taxpayers who file jointly. Single taxpayers earning between $125,000 and $140,000 can make only partial contributions. The same is true for married taxpayers who file jointly earning between $198,000 and $208,000.
Contribution limits For 2020 and 2021, the total contribution limit for all IRAs is $6,000, or $7,000 for individuals 50 and older. The same IRA contribution limits apply. You cannot contribute more than your taxable compensation for the year.
Taxes upon withdrawal Withdrawals are taxed for pre-tax contributions and earnings. Earnings can be withdrawn tax-free as long as you are over 59½ years old. Your contributions can be withdrawn any time without penalties or taxes.
Early withdrawal penalties If you withdraw funds before age 59½, you may be subject to tax on your contributions and earnings plus a 10% additional tax. Withdrawals before age 59½ may incur a 10% tax penalty in addition to taxes on your earnings.
Required minimum distributions A required minimum distribution (RMD) must be taken during the year you turn 72. The SECURE Act of 2019 made changes to RMDs. There are no required distributions during your lifetime. The CARES act of 2020 provides for special distribution options for IRAs.

Income Limits

Anyone over 18 may contribute to a traditional IRA, though high-earners should be aware that tax deductions for contributions to a traditional IRA may be limited or not allowed if they or their spouse is covered by a retirement plan at work and their modified adjusted gross income (AGI) exceeds a certain limit.

For tax year 2021, no deduction is allowed for someone in this situation filing as single or head of household with an AGI of $76,000 or more. For married people filing jointly or a qualified widow(er), no deduction is allowed for an AGI of $125,000 or more.

As the chart above explains, Roth IRAs have an income cap. Individuals who exceed these caps may be limited on how much they can contribute or prohibited from contributing to a Roth IRA completely.

For tax year 2021, a single taxpayer with a modified adjusted growth income of $140,000 or more is not allowed to contribute. The limit is $208,000 for married taxpayers. Single taxpayers earning between $125,000 and $140,000 can make partial contributions. Married taxpayers earning between $198,000 and $208,000 also can make partial contributions.

Contribution Limits

There is a maximum amount any person can contribute to all of their IRAs, whether that is deposited in a single IRA or spread over multiple IRAs. For 2020, the contribution limit is $6,000, though individuals who are 50 or older can contribute $7,000 as part of a “catch-up” policy. Those limits remain the same for tax year 2021.

Distribution Rules

One of the most important distinctions between a traditional IRA and a Roth IRA is that an individual is not required to withdraw funds from a Roth IRA in their lifetime. Individuals with a traditional IRA must begin withdrawing funds during the year they turn 72 (70½ if you turned 70½ in 2019). This single difference makes many individuals select the Roth over a traditional IRA.

The CARES Act also allows for special distributions for 2020.

Pre-Retirement Withdrawals

Withdrawals from a traditional IRA before age 59½ typically trigger a 10% early withdrawal penalty. There are exceptions and life events that allow for early withdrawal. These include permanent and total disability, qualified education expenses, and the qualified first-time purchase of a home.

Similarly, there is a 10% early withdrawal penalty for withdrawing earnings from a Roth IRA before age 59½. Because contributions to a Roth IRA are post-tax, there are no restrictions or penalties for withdrawing original contributions prior to age 59½. Of course, it’s always wise to keep retirement savings invested and growing, but this feature provides flexibility if unexpected financial situations arise.

Other IRA Considerations

Opening an IRA

Many of the same financial institutions where you handle other aspects of your financial life can help you establish an IRA. In addition to brick-and-mortar businesses like banks and credit unions, online options include discount brokerage firms like Charles Schwab, Fidelity, or E-Trade.

Take the time to understand all of the IRA investment options offered by any institution before you decide which one to ultimately go with.

Multiple Retirement Accounts

Aside from the income limitations already addressed, it is possible to have multiple IRAs in addition to participating in a work-sponsored retirement plan. Many people establish what is known as a rollover IRA when they leave a job and wish to move their 401(k) balance from that job into a different retirement vehicle. There are important rules for shifting funds in this sort of situation in order to avoid incurring penalties.

Converting a Traditional IRA to a Roth IRA

You can convert a traditional IRA into a Roth IRA and may wish to do so to take advantage of the unique rules of a Roth IRA. Be aware that a conversion will trigger a tax on any of the untaxed amounts in the traditional IRA.

Which IRA Is Right for Me?

Retirement accounts are built around tax incentives. Traditional IRAs offer qualified participants tax breaks upfront and taxes are incurred upon withdrawing the funds. Roth IRAs do the opposite, as they are funded with post-tax dollars and there are no taxes on withdrawals in retirement. If you expect to be in a lower tax bracket in retirement, then a traditional IRA may be right for you.

However, there are several features of Roth IRAs that make them attractive even to those who may benefit from the upfront tax benefit of a traditional IRA. These include more flexible rules regarding early withdrawals and the fact that you are not required to withdraw any funds from a Roth IRA no matter your age.

Key Takeaways

  • A traditional IRA provides tax incentives on the front end through tax-deductible deposits, while a Roth IRA allows after-tax dollars to grow tax-free and qualified withdrawals in retirement are not taxed.
  • Income caps may prevent high-earners from contributing to a traditional or Roth IRA.
  • For tax year 2021, the annual contribution limit for both a traditional IRA and a Roth is $6,000, or $7,000 for individuals who are over 50 years old.
  • Regardless if a traditional IRA or a Roth IRA better suits your needs, the most important point for both is to begin saving early and stick with it.