Individual Retirement Accounts (IRAs) are a popular way for individuals to save for retirement. There are two main types of IRAs: traditional IRAs and Roth IRAs. Both types of accounts have their own set of advantages and disadvantages, and it is important to understand the key differences before deciding which type of IRA is right for you.
Traditional IRA
A traditional IRA is a type of individual retirement account that allows individuals to save for retirement on a tax-deferred basis. This means that contributions to a traditional IRA are typically tax-deductible, and the money in the account grows tax-free until it is withdrawn. The money saved in a traditional IRA can be invested in various assets such as stocks, bonds, and mutual funds. The account owner can choose from a variety of investment options and can change their investment mix as their needs and goals change over time.
Advantages
- Tax-deductible contributions: Traditional IRA contributions may be tax-deductible, which can lower your taxable income in the year you make the contribution.
- Tax-free growth of funds: The money in a traditional IRA grows tax-free until it is withdrawn. This means that any interest, dividends, or capital gains earned on the investments in the account are not taxed until the money is withdrawn.
- No income limits for contributions: Anyone can contribute to a traditional IRA regardless of their income level, as long as they have earned income.
Disadvantages
- Taxable withdrawals: Traditional IRA withdrawals are taxed as ordinary income in the year they are taken.
- Required Minimum Distributions (RMDs) starting at age 72: Traditional IRA account holders must start taking Required Minimum Distributions (RMDs) from their traditional IRA accounts starting at age 72.
- Higher income earners may not be eligible for the full tax deduction: Individuals who have access to a workplace retirement plan may have limits on the amount of contributions that are tax-deductible based on their income.
Roth IRA
A Roth IRA is another type of individual retirement account that allows individuals to save for retirement on a post-tax basis. This means that contributions to a Roth IRA are made with after-tax dollars, and the money in the account grows tax-free. Withdrawals from a Roth IRA are also tax-free, as long as certain requirements are met. Like a traditional IRA, the money saved in a Roth IRA can be invested in various assets such as stocks, bonds, and mutual funds, and the account owner can choose from a variety of investment options and can change their investment mix as their needs and goals change over time.
Advantages
- Tax-free withdrawals: Withdrawals from a Roth IRA are tax-free, as long as the account has been open for at least five years and the account holder is 59 ½ or older.
- No RMDs: Unlike traditional IRAs, Roth IRAs do not have Required Minimum Distribution (RMD) requirements, so the account holder can keep the money in the account for as long as they want.
- No age limit for contributions: Unlike traditional IRAs, Roth IRAs do not have age limits for contributions, so individuals can continue to contribute to the account even after age 72.
- No income limits for contributions: Unlike traditional IRAs, Roth IRAs do not have income limits for contributions, so anyone can contribute as long as they have earned income.
Disadvantages
- Non-deductible contributions: Contributions to a Roth IRA are made with after-tax dollars, so they are not tax-deductible.
- No immediate tax benefits: Unlike traditional IRAs, Roth IRAs do not offer immediate tax benefits, so individuals will not see a reduction in their taxable income in the year they make a contribution.
Key Differences
Taxes
The main difference between a traditional IRA and a Roth IRA is the way taxes are handled. With a traditional IRA, contributions are made with pre-tax dollars, which can lower your taxable income level in the current year. Withdrawals from a traditional IRA are taxed as ordinary income in the year they are taken. On the other hand, with a Roth IRA, contributions are made with after-tax dollars, and withdrawals are tax-free as long as the account has been open for at least five years and the account holder is 59 ½ or older.
Contributions
Income Limits
Traditional IRAs have no income limits for contributions, but contributions may be limited based on income level and access to a workplace retirement plan. Roth IRAs, on the other hand, have income limits for contributions. In 2022 and 2023, for individuals filing as single, head of household, or married filing separately who did not live with their spouse at any time during the year, the income limit for full contributions is $129,000 and $138,000 respectively. For individuals filing as married filing jointly or qualified widow(er), the income limit for full contributions is $204,000 and $218,000 respectively. Individuals with income above these limits may be eligible for reduced contributions or may not be able to contribute at all.
Roth IRA Income Limits in 2022 and 2023
| FILING STATUS | 2022 INCOME | 2023 INCOME | YOU MAY CONTRIBUTE |
|---|---|---|---|
| Single, head of household or married filing separately (and you did not live with your spouse at any time during the year) | Less than $129,000 | Less than $138,000 | Up to the annual limit |
| $129,000 to $144,000 | $138,000 to $153,000 | A reduced amount | |
| More than $144,000 | More than $153,000 | Zero | |
| Married filing jointly or qualified widow(er) | Less than $204,000 | Less than $218,000 | Up to the annual limit |
| $204,000 to $214,000 | $218,000 to $228,000 | A reduced amount | |
| More than $214,000 | More than $228,000 | Zero | |
| Married filing separately | Less than $10,000 | Less than $10,000 | A reduced amount |
| More than $10,000 | More than $10,000 | Zero |
Traditional IRA Tax Deduction Income Limits for 2022 and 2023
| FILING STATUS | 2022 INCOME | 2023 INCOME | DEDUCTION |
|---|---|---|---|
| Single, head of household or qualifying widow(er) | Less than $68,000 | Less than $73,000 | Full deduction up to the contribution limit |
| $68,000 to $78,000 | $73,000 to $83,000 | Partial deduction | |
| More than $78,000 | More than $83,000 | No deduction | |
| Married filing jointly or qualifying widow(er) | Less than $109,000 | Less than $116,000 | Full deduction up to the contribution limit |
| $109,000 to $129,000 | $116,000 to $136,000 | Partial deduction | |
| More than $129,000 | More than $136,000 | No deduction | |
| Married filing separately | Less than $10,000 | Less than $10,000 | Partial deduction |
| More than $10,000 | More than $10,000 | No deduction |
Withdrawals
Another key difference between a Roth IRA and a traditional IRA is the flexibility of early withdrawals. With a Roth IRA, contributions can be withdrawn free of taxes and penalties at any time, while with a traditional IRA, penalty- and tax-free withdrawals are usually only available after age 59 ½. Withdrawals made before that age are subject to taxes and penalties, unless they are used for certain IRS-approved purposes such as permanent disability, paying higher education expenses or substantially equal periodic payments (SEPPs) under rule 72(t).
Required Minimum Distributions
Another key difference between a Roth IRA and a traditional IRA is the requirement of Required Minimum Distributions (RMDs). Traditional IRA account holders must start taking RMDs from their traditional IRA accounts starting at age 72, while Roth IRA account holders are not required to take RMDs.
Which is better, a Roth IRA or a traditional IRA?
The choice between a Roth IRA and a traditional IRA depends on an individual’s personal circumstances and financial goals. For individuals who expect to be in a higher tax bracket during retirement, a Roth IRA may be a better choice. For individuals who expect to be in a lower tax bracket during retirement, a traditional IRA may be a better choice.
FAQ
Can I Contribute to Both a Traditional and a Roth IRA?
Yes, you can contribute to both a traditional and a Roth IRA, but there are limits to the total amount you can contribute to all IRAs combined. In 2022 and 2023, the contribution limit is $6,500 for individuals under age 50 and $7,500 for individuals 50 and older. However, if income thresholds make direct Roth IRA contributions impossible, you can always opt for a backdoor Roth IRA conversion, which is an IRS-approved strategy that allows high earners to gain access to the benefits of Roth IRA accounts.
Is maxing Out an IRA a Good Idea?
Maxing out an IRA can be a good idea as it allows individuals to save the maximum amount allowed by the IRS each year. However, it is important to consider an individual’s overall financial situation before deciding to max out an IRA. It may be more beneficial for an individual to contribute to an IRA in combination with other retirement savings accounts.
How to convert a traditional IRA to a Roth IRA
Converting a traditional IRA to a Roth IRA can be done by doing a rollover or a trustee-to-trustee transfer of funds from the traditional IRA to a Roth IRA. This can be done at any time, but taxes will be owed on the amount converted.
