Whether you’ve just started your first job or are well into your career, you’re likely to be focused on one key priority: building the best possible retirement savings plan for a comfortable future. No matter where you are in your journey, there are multiple options available to you and many factors to consider.
An individual retirement account, or IRA, for example, can serve as a turbo-booster for your retirement plan. As you save for retirement, it’s important to make sure you’re using the tax benefits of IRAs to your full advantage.
With two types of IRAs to choose from, you have a decision to make: Should you choose a Traditional IRA or Roth IRA?
Greg McBride, a chartered financial analyst and the chief financial analyst at Bankrate, and Brian Martucci, finance editor at financial education website Money Crashers, answer some of the most common questions around choosing a Traditional IRA vs. Roth IRA so you can make an informed decision.
Why contribute to an IRA?
Before we dive into the differences between Traditional and Roth IRAs, let’s review why IRAs are such an effective tool to save for retirement in the first place.
IRAs provide tax-advantaged ways to save for retirement. In other words, you may pay less in taxes when you use an IRA versus a personal brokerage account, which means you can enjoy a bigger nest egg in your golden years.
If you’re self-employed or don’t have access to an employer-sponsored account such as a 401(k), then an IRA can be your go-to account for building up your retirement savings while reducing your taxes. Even if you have a retirement account through your employer, you can supplement that savings with an IRA, a strategy many experts recommend.
That’s because IRAs often offer a much broader field of savings and investment options than many workplace plans, Martucci notes. Possibilities within an IRA—whether you have a Traditional IRA or Roth IRA—include IRA savings accounts, IRA certificates of deposit, money market accounts and investments (e.g., stocks and bonds).
Plus, with longer retirements becoming common, a larger pot of savings can bring peace of mind. “If you can afford to make contributions and don’t need the money for day-to-day spending or shorter-term financial goals, why not do so?” Martucci says.
Am I allowed to contribute to an IRA?
As long as you earn income, you can contribute to an IRA to save for retirement. You’re also eligible if you filed taxes jointly with a spouse who has income from employment.
Anyone earning income can contribute to a Traditional IRA. Martucci notes that if you or your spouse are covered by a retirement plan at work, then you can only deduct your contributions from your taxable income if your modified adjusted gross income is within ranges specified by the IRS.
To even contribute to a Roth IRA, you must meet certain income requirements. In 2020, for example, you had to earn less than $139,000 (if filing singly) or $206,000 (if filing jointly with your spouse) in order to contribute to a Roth IRA.
It used to be that Traditional IRA contributions were not allowed after age 70½, but the passage of the SECURE Act of 2019 changed that.
As of tax year 2020, there are no age limits for contributing to Traditional IRAs or Roth IRAs. You can start contributing—and keep contributing—throughout your life.
For the 2020 tax year, contribution limits stand at $6,000 per year before age 50 and $7,000 per year after age 50, but be sure to check the latest contribution limits defined by the IRS.
What’s the difference between Traditional IRAs and Roth IRAs?
When it comes to Traditional IRAs vs. Roth IRAs, they both have tax advantages. It’s the way their tax breaks work—as well as a few other nuances—that separates them.
Traditional IRAs: Deduct from taxes now, but pay later
If you qualify to deduct your contributions to a Traditional IRA from your taxes, then you’ll be happy to see a reduction in your tax bill. But Martucci explains that when you withdraw those funds from your Traditional IRA in retirement, those distributions are taxed as ordinary income.
One difference between a Traditional IRA and a Roth IRA is that with a Traditional, you can take a full deduction up to the amount of your contribution limit every tax year before you retire. You can take these deductions if your modified adjusted gross income is $65,000 or less (if filing singly) or $104,000 or less (if married and filing jointly).
Roth IRAs: Pay taxes now, but not in retirement
With Roth IRAs, it works the other way around. You contribute after-tax funds to a Roth IRA. When you withdraw from your Roth IRA account in retirement, however, you can do so tax-free.
Basically, McBride says, you will pay taxes one way or the other. With Traditional IRAs, you pay later. With Roth IRAs, you pay now.
Required minimum distribution (RMD) rules
Tax rules are an important difference between Traditional IRAs and Roth IRAs, but they also have different rules for when you are required to withdraw funds.
Martucci notes that Traditional IRA holders must begin withdrawing funds the year they turn 72.** Roth IRA holders, on the other hand, aren’t bound by RMD rules—an advantage if you don’t need the funds at that point.
Early withdrawal penalties
Because IRAs are designed specifically to help Americans save for retirement, there are withdrawal penalties designed to prevent people from pulling money out early from either a Traditional IRA or a Roth IRA.
If you withdraw money from a Traditional IRA before you’re 59½, you may get hit with an additional early withdrawal tax of 10% on the amount you withdrew—and that’s on top of any taxes you’ll need to pay.
With Roth IRAs, the early withdrawal rules are a little different. Because you already paid taxes on your contributions, you can pull them out of your Roth IRA penalty-free at any age. But if you withdraw any earnings on your contributions before 59½, you’re on the hook for the 10% early withdrawal tax plus income taxes. This is the case unless the distribution is considered a “qualified distribution” by the IRS.
Traditional IRA vs. Roth IRA: Which should you choose?
Before you stress out about making the wrong choice when comparing Traditional vs. Roth IRAs, McBride and Martucci want you to keep in mind that they are both wise choices. Either way, you’re taking advantage of tax breaks to save for retirement, and that’s a smart financial decision you should be proud of.
When deciding whether you should choose a Traditional IRA or Roth IRA, the general rule of thumb is to contribute to a Roth if you think you’ll be in a higher tax bracket in retirement than you are in now. If you think you’ll be in a lower tax bracket in retirement, conventional wisdom says you should contribute to a Traditional IRA.
However, McBride and Martucci agree that it can be difficult to predict what your future tax rate will be. That’s because tax rates often change, so you can’t assume they will be the same when you retire as they are today.
Because Traditional IRAs are bound by RMD rules, there is the possibility that those required withdrawals, which are considered income, could bump you into a higher tax bracket while in retirement.
“One of the advantages of a Roth is it helps people avoid having this big tax bomb in retirement because there are no required minimum distributions for Roth IRAs, and earnings from a Roth aren’t taxed anyway,” McBride says.
The bottom line? Don’t spend too much time worrying about how your future taxes will be affected by your IRA choice today. As long as you’re investing in an IRA—Traditional IRA or Roth IRA—you’re on the right track. Just try to avoid the common retirement mistake of putting off saving for too long.
Consider both a Traditional IRA and a Roth IRA
Still can’t decide between a Traditional IRA or a Roth IRA? Good news: You can use both types of IRAs.
“It certainly makes sense to have multiple IRAs for tax optimization and diversification purposes,” Martucci says. He notes that your annual contribution limit applies to the total of both IRAs combined.
If you use both, he recommends holding higher-growth-potential investments (such as individual stocks or exchange-traded equity funds) in your Roth IRA. On the other hand, he recommends holding lower-risk, potentially lower-return vehicles (such as municipal bonds or IRA savings accounts) in your Traditional IRA to avoid excessive taxes on withdrawals.
Now that you have a solid understanding of the differences between Traditional and Roth IRAs, you can confidently put your IRA accounts to work toward your retirement goals.
Your retirement might feel like it’s a long way off, but the sooner you can start the journey, the better. Explore the ways that Discover IRA Accounts can help you get there.
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* The article and information provided herein are for informational purposes only and are not intended as a substitute for professional advice. Please consult your tax advisor with respect to information contained in this article and how it relates to you.
** Distributions are required to start by age 70½ if you were 70½ by 12/31/2019. If you turn 70½ in 2020 or years following, distributions will not be required until you are age 72.