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Investing

Is a Roth or Traditional IRA Better? It Depends

January 20th, 2016 | 4 min. read

By Jacob Schroeder

The choice between a Roth and traditional IRA is a common retirement planning dilemma that requires a review of your current financial situation – and a little time travel.

No, this isn’t the premise of a bad science fiction movie, but rather an essential part of any retirement planning process. Often, smart financial decisions involve a look toward the future. You have to travel in time (metaphorically speaking, of course) and meet your future self. Ask your future self about his or her lifestyle, adjusted gross income, discretionary expenses, hopes and dreams, etc.

Saving and investing for retirement is a long-term enterprise. Where you want to be in the future influences your decisions in the present. This includes choosing the right investment retirement account. The differences between Roth and traditional IRAs can be either advantages or disadvantages depending on where you are today and where you’ll be tomorrow.

To help you decide which account makes the most sense for you, let’s compare the major differences between a Roth and traditional IRA.

Taxes

The most consequential difference between a Roth and traditional IRA is in how they are taxed.

 

Roth IRA

Traditional IRA

Contributions

After-tax

Tax-deductible. Your deduction may be reduced or eliminated if you or your spouse participates in a retirement plan at work and your income exceeds certain levels.

Earnings

Tax-free

Tax-deferred

Withdrawals

Tax-free

Taxed as ordinary income

 If you expect to fall under a higher tax bracket in the future, then a Roth IRA is likely a better choice. That’s because Roth contributions are taxed upfront, as they are made with after-tax income. Roth earnings and withdrawals are not taxed, as long as you take them after you turn age 59 ½ and have had a Roth account for at least five years.

Conversely, traditional IRAs are taxed on the backend. Contributions are essentially pre-tax dollars because they are tax-deductible. Though be aware that your deduction may be reduced or eliminated if you or your spouse participates in a retirement plan at work and your income exceeds certain levels. (IRA deduction limits can be found on the IRS website.) while earnings are tax-deferred and withdrawals are taxed as ordinary income. Therefore, if you plan to be in a lower tax bracket in retirement, a traditional IRA may make more sense for you.

In the event you remain in the same tax bracket your entire life, both options will generally work out the same.

Of course, it is difficult to determine with certainty what tax bracket you’ll fall under in the future; especially, if you are now starting your career. Plus, the government can always change tax laws and rates. Nonetheless, you can make some general assumptions. Your income tax rate will likely rise as your career progresses and then drop in retirement when you are no longer earning a salary. Keep in mind that it is possible to be in a higher tax bracket in retirement based on the amount of your IRA distributions (see RMDs below) and any additional earnings.

Generally, younger retirement savers may find more benefits from a Roth IRA. Meanwhile, those in the middle stages or later in their careers will likely opt for a traditional IRA, with the potential to convert it into a Roth IRA later.

When it comes to tax-related issues, you should seek the help of a tax professional.

Income Limits on Contributions

There are additional differences between Roth and traditional IRAs that may factor into your decision. For one, your eligibility to contribute to an IRA depends on the size of your income.

 

Roth IRA

Traditional IRA

Single (2016)

$117,000 - $132,000: reduced amount

More than $132,000: Ineligible

No income limit on contributions

Married, filing jointly (2016)

$184,000 - $194,000: reduced amount

More than $194,000: Ineligible

No income limit on contributions

 Those with an annual income greater than $132,000, when filing single, or $194,000, if married and filing jointly, are ineligible to contribute to a Roth IRA. Further, those who earn between $117,000 and $132,000, when filing single, or $184,000 and $194,000, if married and filing jointly, fall in a “phase-out” area and can only contribute at a reduced amount. There are no income restrictions on contributions to a traditional IRA.

RMDs

In addition to tax-free withdrawals, another advantage of Roth accounts is the exemption from required minimum distributions (RMDs).

 

Roth IRA

Traditional IRA

Must you take required minimum distributions?

No RMDs during your lifetime

Yes. First RMD by April 1 of the year following the year you reach age 70½. An annual RMD by December 31 for each subsequent year.

 When you turn 70 ½ years of age, you are required to withdraw a certain amount from your retirement accounts – traditional IRAs, 401(k)s, etc. – each year. Those RMDs are taxed as ordinary income. Also, failing to take your full RMD can result in a significant penalty.

If you expect to use your retirement account as a source of income by making consistent withdrawals, then this difference may not matter. On the other hand, those who plan to pass on their savings to their children may want to consider a Roth.

Early withdrawal penalties

Hopefully, you will not have to tap any of your retirement accounts early. (Your future self will not likely appreciate it!) Yet, life events such as a medical emergency can make it unavoidable.

 

Roth IRA

Traditional IRA

Penalty for withdrawals before age 59 ½

No tax or penalty on contributions. Income tax and 10% penalty on earnings.

Income tax and 10% penalty on contributions and earnings

With a traditional IRA, a steep 10% federal tax penalty is applied to the early withdrawal (before age 59 ½) of contributions and earnings. A Roth IRA provides greater flexibility. You can withdraw contributions, but not earnings, early without triggering the 10% federal tax penalty.

There are qualifying exceptions for both accounts, including: first-time home purchases, postsecondary education expenses, health insurance premiums after 12 weeks of unemployment, and disability or death. You can find a list of exceptions to taxes on early distributions on the IRS website.

The choice between a Roth and traditional IRA can be difficult because you may not realize your mistake until it’s too late. It’s important to weigh the pros and cons of each in relation to your current financial circumstances and long-term goals, and seek professional guidance from a financial adviser if you are uncertain.

Ultimately, whichever retirement account you choose, try to maximize your savings. Both Roth and traditional IRAs have the same contribution limits for 2016: $5,500 ($6,500 if you’re age 50 or older). It can help you become the person you hope to be in the future.