When you invest in an IRA, you have two choices — a traditional vs. a Roth IRA. The two plans grow funds in much the same way, with one noticeable difference: How your contributions and withdrawals are taxed.
Here’s a quick explanation of the differences:
What is a traditional IRA?
A traditional IRA is a retirement savings account in which you place investments. Stocks, bonds, mutual funds, and CDs may all be part of an IRA.
You make regular contributions to the plan with pretaxed money, and any earnings are tax deferred until you withdraw them in retirement.
If you withdraw money at any time prior to age 59 and a half, you will be charged a 10 percent penalty in addition to any taxes. Upon withdrawal after age 59 and a half, distributions are taxed as ordinary income.
What is a Roth IRA?
Roth IRAs offer the same investment opportunities as IRAs and have the same annual contribution limits.
While a traditional IRA is paid for with pretax money, Roth IRA contributions are taxed in the year contributions are made. Contributions then grow tax-free, and any retirement distributions are also tax-free.
Traditional IRA vs. Roth IRA
When weighing a traditional vs. a Roth IRA, you need to consider which gives you the best tax savings. If you expect your taxes will be lower in retirement due to reduced income, opting for a traditional IRA gives you an upfront tax advantage. And you’ll pay less tax on distributions.
If, however, you expect to be taxed at a higher rate in retirement, a Roth IRA is the better choice, as your earnings and withdrawals will be tax-free.
The trick, of course, is predicting what your tax rate will be upon retirement based on your retirement plan and current investments.
Pro tip! This Roth vs. traditional IRA calculator can help you estimate which type of IRA offers the best tax savings. Remember, though, that a calculator cannot consider unexpected events, such as market fluctuations or changes to your employment or income.
The maximum contribution for both traditional and Roth IRAs is $6,000 annually, increasing to $7,000 a year after age 50. Roth IRA deductions may also be limited by your tax filing status and income:
- Single people and heads of households must earn less than $122,000 to contribute the full amount to a Roth IRA.
- Married couples filing jointly and qualified widows/widowers must earn less than $193,000.
Can I contribute to both?
Presuming you are eligible for a Roth IRA, you can contribute to both. The total amount contributed to both accounts cannot exceed your annual IRA contribution limit.
The bottom line
Both Roth and traditional IRAs offer tax advantages, just at different times in the account’s life span. Your current and future income determine which is best for you. If you’re looking for more comprehensive advice on retirement planning, check out our guide here.