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

It's all about when you want to pay taxes

Couple talking to an advisor about Roth and traditional IRAs
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Individual retirement arrangements (IRAs) are savings accounts that have tax and growth advantages over other types of accounts. There are two types you can choose from—a traditional IRA or a Roth IRA. The main differences between the two are when you pay taxes and when you need to begin withdrawing from them.

What's the Difference Between a Roth IRA and a Traditional IRA?

Traditional IRA Roth IRA
Tax Benefits Tax-deductible contributions and tax-deferred growth Tax-free growth potential, qualified withdrawals are tax-free, non-deductible contributions
Income Requirements No income limitation Has income limitations
Required Minimum Distributions Must take required minimum distributions No required minimum distributions
Early Withdrawals Full amount penalized Only earnings are penalized

Tax Benefits

Contributions to a traditional IRA may be tax-deductible at the time they are made. However, 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.

Anyone over 18 may contribute to an IRA. However, high-earners should be aware that tax deductions for contributions to a traditional IRA may be limited or not allowed in a few circumstances. If you or your spouse has a retirement plan at work and your modified adjusted gross income (AGI) exceeds a certain limit, you might not be eligible.

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.

Contributions to a Roth IRA are not tax-deductible since withdrawals are not taxed.

For the tax year 2021, no deduction is allowed if you file as single or head of household with an AGI of $76,000 or more. In addition, if you're married filing jointly or a qualified widow(er), you cannot take a deduction if you have an AGI of $125,000 or more.

If you or your spouse don't have a plan at work, you're able to fully deduct your contributions if you make less than $208,000 combined or partially if your combined incomes are between $198,000 and $208,000.

Income Requirements

As the chart above explains, Roth IRAs have an income cap. If you exceed these caps, you may be limited on how much you can contribute (or be prohibited from contributing) to a Roth IRA.

For the tax year 2021, if you're a single taxpayer with a modified adjusted growth income of $140,000 or more, you cannot contribute to a Roth IRA. However, if that's you, and you earn between $125,000 and $140,000, you can make partial contributions.

Traditional IRAs do not have income caps, only contribution limits.

The income limit is $208,000 for married taxpayers who file jointly, but you can make partial contributions if you earn between $198,000 and $208,000.

Distribution Rules

One of the most important distinctions between a traditional IRA and a Roth IRA is that you're not required to withdraw funds from a Roth IRA—you have already paid taxes on the funds. However, since taxes on a traditional IRA are deferred, the government requires withdrawals so that you pay taxes.

Early Withdrawals

If you have a traditional IRA, you must begin withdrawing funds once you turn 70.5 or 72, depending upon your date of birth. This single difference makes many individuals select the Roth over a traditional IRA.

Withdrawals from a traditional IRA before age 59.5 typically trigger a 10% early withdrawal penalty. However, 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 59.5. However, because contributions to a Roth IRA are post-tax, there are no restrictions or penalties for withdrawing your original contributions before age 59.5. Of course, it’s always wise to keep retirement savings invested and growing, but this feature provides flexibility if unexpected financial situations arise.

The CARES Act waived RMDs for 2020, but RMDs are required for 2021, before December 31.

Other IRA Considerations

There are many other factors to consider when you're comparing Roth and traditional IRAs. Some of the most important considerations are:

  • Who you open the account with
  • Having multiple accounts
  • How much you can contribute
  • Changing your mind on the type of IRA

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.

Each broker will have different options for you to choose from and different investment types within each of their packages. Ensure you know what asset types the IRA you're considering is composed of (stocks, bonds, other funds), and ensure you're comfortable with the risks of investing in the IRA you choose.

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. For example, 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 to avoid incurring penalties.

Contribution Limits

There is a maximum amount you can contribute to all of your IRAs, whether that is deposited in a single IRA or spread over multiple IRAs. For 2021, the contribution limit is $6,000, although if you're 50 or older, you can contribute $7,000 as part of a “catch-up” policy.

Converting a Traditional IRA to a Roth IRA

If your situation changes mid-career or you change your mind about the type of IRA you need, you can convert a traditional IRA into a Roth IRA. This is beneficial when your tax bracket changes or you decide you'd rather have the tax-free withdrawals of a Roth IRA. However, be aware that a conversion will trigger a tax on any of the untaxed amounts in the traditional IRA.

Which IRA Is Right for You?

Deciding which IRA you should have depends on your earnings and tax situation when you begin contributing; it also depends on your financial circumstances when you expect to begin your withdrawals.

Retirement accounts are built around tax incentives. Traditional IRAs offer qualified participants tax breaks upfront, and taxes are only 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 than you are now, then a traditional IRA may be right for you. However, if you'll pay fewer taxes when you contribute, it might be worth it to look into a Roth IRA.

Apart from taxes, if you want to begin your withdrawals early, Roth IRAs don't have early withdrawal penalties on original contributions like traditional IRAs. So if you leave the earnings untouched until age 59.5, you can make withdrawals on your principal.

The Bottom Line

The tax benefits and required minimum distributions are the keys to deciding which one of the two retirement accounts is best for you. It helps to work through your finances to see where you are now and where you'll be when you want to retire to decide which is best for you.

If you still can't decide, discuss your plans and intentions with a financial advisor. They can help you weigh the features and benefits of both against your financial situation and help you forecast a realistic financial future.

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 Roth IRA.
  • For the 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 age 50 or older.
  • It helps to forecast the tax bracket you'll be in when you want to retire so that you can decide which type is best for your current and future financial circumstances.