Planning for your retirement is essential, and knowing the differences between a traditional IRA and a Roth IRA can play a significant role in building your financial future during those years. Both IRA’s offer valuable benefits, but they come with varying income limits, arrangements, and respective pros and cons.
Traditional IRA: The traditional IRA offers a tax advantage as you save for retirement. Here’s how it works: Let’s say you contributed $5,000 to a traditional IRA this year, you may be able to deduct that $5,000 on your tax return. This allows you to have a nice break on your taxes to the IRS. If you’re filing individually and under the age of 50, you’re allowed to contribute $6,500 annually. If you’re over 50 and filing individually, you can contribute up to $7,500 annually.
Once you reach age 59 ½, you can start making withdrawals from your traditional IRA that are penalty-free. However, by the age of 73, you will be required to begin making withdrawals from your IRA. A very important aspect of the traditional IRA which you must understand is that when you withdraw funds, you will be taxed on both your contributions and any gains you have accumulated over the years. This is a main differentiator from the Roth IRA, where qualified withdrawals are 100% tax-free.
In summary, the traditional IRA offers immediate tax benefits, the potential for tax-deferred growth, and required withdrawals by the age of 73.
Roth IRA: The Roth IRA offers a different tax approach in comparison to the traditional IRA. Instead of getting your tax benefits immediately, you’ll get them during your retirement. Let’s go through another example on this. Instead of contributing $5,000 to a traditional IRA, you decided to contribute that money to a Roth IRA this year. The $5,000 you contribute to your Roth IRA is all after-tax money, so it’s not deductible on your current tax return. Although the contribution limits for a Roth IRA are the same as the traditional IRA, you can consider a Backdoor Roth strategy to counter this.
With the Roth IRA, there is no set time for when you must start taking withdrawals, unlike the traditional IRA’s mandatory withdrawals. The Roth gives you the flexibility to let the money in your account grow indefinitely and even pass the money along to your beneficiaries in an estate plan.
The advantages of the Roth IRA become apparent when you begin to make withdrawals during retirement. Let’s say your Roth IRA has grown to a value of $1,000,000 and you are over the age of 59 ½. Any withdrawals you make on that account are taken out 100% tax-free, which is the true shine of the Roth IRA.
Traditional IRA and Roth IRA: The Main Differences
The traditional IRA and the Roth IRA differ mostly in tax treatment and timing. With the traditional IRA, you reap the tax benefits today, allowing you to deduct your contributions from your current taxes. However, you will need to pay taxes on your withdrawals in retirement.
On the other hand, the Roth IRA allows you to enjoy the tax benefits in your retirement as you can withdraw funds tax-free. Although with the Roth, your contributions are made after-tax, which does not provide any immediate tax benefits.
Knowing if You’re Eligible for An IRA
To be eligible to contribute to an IRA, you (and/or your spouse if applicable) must have earned income equal to or greater than the total amount of contributions you make for the year. With both the traditional IRA and the Roth IRA, there is no age limit to being eligible for this account.
However, with the Roth IRA there is an income contribution to be aware of. For 2023, if you are filing individually, your maximum MAGI (marginal adjusted gross income) cannot exceed $138,000 for a full Roth contribution. For a partial contribution, you can qualify if your MAGI falls within the range of $138,000 to $153,000. If you surpass these income limits, there is still a way to contribute to a Roth IRA through a backdoor Roth. It is important to note that successfully navigating this method can be tricky, which is why it’s crucial to consult with a financial advisor for guidance.
Traditional Vs. Roth