Whether to use a traditional or a Roth IRA is a decision anyone saving for retirement with an IRA must make. Both types of IRAs allow you to accumulate significant funds for retirement, but each provides different tax advantages. The answer to the question of “Which is the better IRA for me?” is not the same for everyone. The answer depends on an individual’s income, current tax bracket, future tax bracket, marital status, etc. The answer in many cases is that both types will provide valuable benefits.
A traditional IRA allows an individual who has earned income to make potentially tax-deductible annual contributions.1 You can contribute any amount up to $6,000 for 2020 ($7,000 if you are 50 or older). One of the main incentives for making annual contributions to a traditional IRA is the ability to take a tax deduction, which depends on whether you or your spouse participate in a retirement plan at work and your level of income. Another important feature is that traditional IRAs can accept rollovers from your workplace retirement plan when you change jobs or retire. This allows you to continue growing these savings on a tax-deferred basis, as well as consolidate your pre-tax retirement savings into one account.
You can take distributions from an IRA at any time. Distributions are generally taxable in the year of the distribution (and subject to a 10% penalty if you are not yet 59½). When you reach age 72, you must begin taking a minimum distribution from your traditional IRA each year (i.e., begin paying tax on those tax-deferred dollars).2
A traditional IRA may be a good choice if you
• Would like a tax deduction for your retirement contributions
• Believe you will be in a lower tax bracket at retirement than you are now
• Have income above the limits permitted to contribute to a Roth IRA
• Are receiving a taxable distribution from an employer’s retirement plan and want to continue to defer taxation on your savings and investment earnings
A Roth IRA allows an individual who has earned income within certain limits to make after-tax contributions, subject to the same annual contribution limits as a traditional IRA. Tax deductions are not available for Roth IRA contributions, but a Roth IRA offers a unique tax benefit: the potential for tax-free growth of investment earnings.
Like traditional IRAs, Roth IRAs can receive rollovers. You can roll over assets from a designated Roth account in a 401(k) plan or 403(b) plan to a Roth IRA in a tax-free transaction. You can also roll over your pre-tax assets in an employer plan to a Roth IRA. Pre-tax assets rolled over to a Roth IRA are taxable in the year they are distributed from the employer plan. Once the pre-tax assets are converted to Roth status, these assets are treated as basis (after-tax assets) in the Roth IRA and are subject to the Roth distribution rules.
Roth IRAs allow distributions at any time, but the taxation of a Roth distribution is different from that of a traditional IRA distribution. You will never be taxed on a distribution of your annual Roth contributions or pre-tax assets that have been rolled over to your Roth IRA. The earnings in the Roth IRA will also be distributed tax-free if the distribution is a “qualified distribution.” A distribution is qualified if five years have passed since the first year of contribution, and you have reached 59½, died, become disabled, or are making a first-time home purchase. If a Roth IRA distribution is not qualified, the earnings portion of the distribution is taxable (and may be subject to a 10% penalty if you are not yet 59½).
A Roth IRA may be a good choice if you
• Want to pay tax at today’s rates because you believe income tax rates will rise in the future or you will be in a higher tax bracket when you retire
• Have time to accumulate significant investment earnings before retirement
• Want access to tax and penalty-free funds before retirement
• Would like to pass retirement assets to your heirs tax-free as part of your estate plan
Let’s look at a simple example to illustrate the different rules for traditional vs. Roth IRAs. Abby is 30 years old, works for an employer who doesn’t have a retirement plan, and earns $50,000 a year. She could contribute up to $6,000 per year to a traditional or Roth IRA. If she contributes to a traditional IRA, she will receive a tax deduction and the contribution will grow tax-deferred until she takes a distribution. If the tax deduction is important to her now, or she believes she will be in a lower tax bracket at retirement, a traditional IRA may be the more attractive option for her. In contrast, contributions to a Roth IRA will not be deductible but the growth in the Roth account will be tax-free if Abby waits until she is at least 59½ to take a distribution of the earnings in the account. As a young saver in a lower tax bracket and with many years for her Roth IRA investments to grow in value, a Roth IRA may be a more attractive alternative.
Many factors affect the decision of which type of IRA may be most beneficial for you. Some people use both types of IRAs to diversify the tax nature of their retirement savings. If you meet the eligibility requirements, you can contribute to both a traditional and Roth IRA in the same year up to the $6,000 (or $7,000) limit in aggregate. You may want to seek tax or financial planning advice to help you consider all the factors that could affect your decision.
1 To be eligible to make a traditional IRA contribution for 2019 (or a prior year), the IRA owner had to be younger than age 70½.
2 Required minimum distributions started at age 70½ for retirement savers who reached age 70½ by December 31, 2019.