Traditional IRA vs. Roth IRA
Trying to decide between a Traditional IRA or a Roth IRA? Here are the differences.
Note: The article below refers to the 2012 tax year. Assuming your IRA was opened by Dec. 31, 2012, you have until the tax filing deadline–April 15, 2013–to make a 2012 contribution. While the general comparison is the same for 2013, the income/contribution limits have increased for the 2013 tax year. Click here for the details.
The type of individual retirement account you choose can significantly affect you and your family’s long-term savings. So it’s worth understanding the differences between traditional IRAs and Roth IRAs in order to select the best one for you.
Here are the key considerations:
Anyone with earned income, who is younger than 70 ½, can contribute to a traditional IRA. Roth IRAs, however, have income-eligibility restrictions: Single tax filers, for instance, must have modified adjusted gross incomes of less than $125,000 in 2012 to contribute to a Roth IRA. (Contribution limits are phased out starting at $110,000 in modified AGI, per IRS guidelines.) Married couples filing jointly must have modified AGIs of less than $183,000 in 2012 in order to contribute to a Roth; contribution limits are phased out starting at $173,000. You can also see the full 2012 income limits here.
Both traditional and Roth IRAs provide generous tax breaks. But it’s a matter of timing when you get to claim them. Traditional IRA contributions are tax deductible on both state and federal tax returns for the year you make the contribution, while withdrawals in retirement are taxed at ordinary income tax rates. Roth IRAs provide no tax break for contributions, but earnings and withdrawals are generally tax-free. So with traditional IRAs, you avoid taxes when you put the money in. With Roth IRAs, you avoid taxes when you take it out in retirement.
Future Tax Rates
Deciding to contribute to a traditional or Roth IRA should depend on whether you expect your income tax rate in retirement to be higher or lower than what you currently pay. That’s because it determines whether the tax rate you pay on your Roth IRA contributions (today’s tax rate) is higher or lower than what you’d pay on your traditional IRA’s withdrawals in retirement.
Of course, it’s hard to predict what federal and state tax rates will be 10, 20 or even 40 years from now. But you can ask yourself some basic questions to help determine your personal situation: Which federal tax bracket are you in today? Do you expect to your income including Social Security to increase or decrease in retirement? Although conventional wisdom suggests that gross income declines in retirement, taxable income sometimes does not. Think about it. Once the kids are grown and you stop saving for retirement, you lose some valuable tax deductions and tax credits, leaving you with higher taxable income in retirement.
What about tax rates? Do you expect your tax rate will be higher or lower when you retire? Given today’s historically low federal tax rates and large U.S. deficit, many economists believe federal income tax rates will rise in the future — meaning Roth IRAs may be the better long-term choice.
One major difference between traditional IRAs and Roth IRAs is when the savings must be withdrawn. Traditional IRAs require you to start taking required minimum distributions (RMDs) at age 70 1/2. Roth IRAs, on the other hand, don’t mandate withdrawals during the owner’s lifetime. So, if you don’t need the money, Roth IRAs can continue to grow tax-free throughout your lifetime, making them ideal wealth-transfer vehicles. Beneficiaries of Roth IRAs don’t owe income tax* on withdrawals and can stretch out distributions over many years.
Both traditional and Roth IRAs allow owners to begin taking penalty-free, “qualified” distributions at age 59 ½. However, Roth IRAs require that the first contribution be at least five years before qualified distributions begin.
Extra Benefits & Considerations
It’s also worth factoring in some of the specific rules and benefits of traditional and Roth IRAs. Here’s a breakdown:
- Contributions to traditional IRAs lower your taxable income in the contribution year. That lowers your adjusted gross income, helping you qualify for other tax incentives you wouldn’t otherwise get, such as the child tax credit or the student loan interest deduction.
- Up to $10,000 can be withdrawn without the normal 10% early-withdrawal penalty to pay for qualified first-time homebuyer expenses. However, you’ll pay taxes on the distribution.
- Roth contributions (but not earnings) can be withdrawn penalty- and tax-free any time, even before age 59 ½.
- five tax years after the first contribution, you can withdraw up to $10,000 of Roth earnings penalty-free to pay for qualified first-time homebuyer expenses.
Keep in mind that Congress can change these rules at any time. So while these are the rules today, they may be very different when you retire.
2012 Contribution Limits
$5,000; $6,000, if age 50 or older
$5,000; $6,000, if age 50 or older
2012 Income Limits
Single tax filers with modified AGIs of less than $125,000 (phase-out begins at $110,000); married couples filing jointly with modified AGIs of less than $183,000 (phase-out begins at $173,000)
Anyone with earned income can contribute but tax deductibility is based on income limits and participation in employer plan
No tax break for contributions; tax-free earnings and withdrawals in retirement
Tax deduction in contribution year; ordinary income taxes owed on withdrawals
Contributions can be withdrawn at any time, tax-free and penalty free. After five years and age 59 ½, all withdrawals are tax-free, too. No withdrawals required during account holder’s lifetime; beneficiaries can stretch distributions over many years
Withdrawals are tax-free and penalty free beginning at age 59 ½. Distributions must begin at age 70 1/2 ; beneficiaries pay taxes on inherited IRAs.
After five years, up to $10,000 of earnings can be withdrawn penalty-free to cover first-time homebuyer expenses.
Contributions lower taxpayer’s AGI, potentially qualifying them for other tax incentives; up to $10,000 penalty-free withdrawals to cover first-time homebuyer expenses, but taxes due on distributions.