Note: The article below refers to the 2018 tax year. You have until the tax filing deadline—April 15, 2019—to make a 2018 contribution. Click here for Roth IRA Eligibility rules, or visit these links for current contribution limits or current income limits.
Comparing Roth and Traditional IRAs
Trying to decide between a Traditional IRA or a Roth IRA?
The type of individual retirement account (IRA) you choose can significantly affect your 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 70½ can contribute to a Traditional IRA. Whether the contribution is tax deductible depends on your income and whether you or your spouse (if you’re married) are covered by a retirement plan through your job, such as a 401(k). Click here for details from the IRS.
Roth IRAs don’t have age restrictions, but they do have income-eligibility restrictions: In 2018, single tax filers, for instance, must have modified adjusted gross incomes of less than $135,000 to contribute to a Roth IRA. (Contribution limits are phased out starting with a modified AGI of $120,000—per IRS guidelines.) Married couples filing jointly must have modified AGIs of less than $199,000 in order to contribute to a Roth; contribution limits are phased out starting at $189,000.
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; 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.
With Traditional IRAs, you avoid taxes when you put the money in. “With a Roth IRA, in retirement you won’t have to pay any taxes upon withdrawals of funds,” says Levi Sanchez, CFP®, cofounder of Millennial Wealth, Seattle, Wash.
“Since Roth IRA contributions are made on an after-tax basis, it is nice to take advantage of the time value of money and tax-free growth, especially if you are in a lower tax bracket today,” says Marguerita Cheng, CFP®, CRPC®, RICP, CDFA , CEO, Blue Ocean Global Wealth, Gaithersburg, Md.
Of course, with both types of IRAs, you pay no taxes whatsoever on all of the growth of your contributed funds, as long as they remain in the account.
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)—mandatory, taxable withdrawals of a certain percentage of your funds—at age 70½, whether you need the money at that point or not. Roth IRAs, on the other hand, don’t require any withdrawals during the owner’s lifetime. If you have enough other income, you can let your Roth IRAs continue to grow tax-free throughout your lifetime, making them ideal wealth-transfer vehicles.
The same applies to your heirs. Beneficiaries of Roth IRAs don’t owe income tax on withdrawals and can stretch out distributions over many years. However, beneficiaries may still owe estate taxes.
Both Traditional and Roth IRAs allow owners to begin taking penalty-free, “qualified” distributions at age 59½. However, Roth IRAs require that the first contribution be made at least five years before the first withdrawal, in order to avoid incurring a tax payment. If you meet that benchmark (and you only have to meet it once), you will have only paid taxes on what went into the account, not the sum you eventually take out.
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 generally 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. (Note that if you or your spouse has an employer retirement plan, your ability to deduct contributions may be reduced or eliminated.)
- If you are under 59½, you can withdraw up to $10,000 from your account without the normal 10% early-withdrawal penalty to pay for qualified first-time home-buyer expenses and for qualified higher education expenses. Hardships such as disability and certain levels of unreimbursed medical expenses may also be exempt from the penalty, However, you’ll still pay taxes on the distribution.
- Roth contributions (but not earnings) can be withdrawn penalty- and tax-free at any time, even before age 59½.
- If you are under 59½, you can withdraw up to $10,000 of Roth earnings penalty-free to pay for qualified first-time home-buyer expenses, provided at least five tax years have passed since your initial contribution.
- Roth IRAs can be invested in virtually anything you want: index funds, lifecycle funds, individual stocks, or manyalternative investments.
Future Tax Rates
Deciding between a Traditional and a Roth IRA depends, basically, on how you think your income—and by extension, your income tax bracket—will compare to your current situation. In effect, you’re trying to determine whether the tax rate you pay on your Roth IRA contributions today will be greater or smaller than the rate you’ll be paying on distributions from your Traditional IRA after you’ve retired (or have to start making them, at age 70½).
Of course, it’s hard to predict what federal and state tax rates will be 10, 20 or 40 years from now. Given today’s historically low federal tax rates and the 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. But of course, no one knows.
“I often mention to clients who can contribute to both pre-tax and after-tax accounts that it’s great to have options to decide which tax pot to pull from in retirement based upon the specific tax year and situation that arises,” says Martin A. Federici, Jr., AAMS®, CEO of MF Advisers, Inc., Dallas, Pa. “Everyone knows that tax scenarios can change from year to year (sometimes for the good, sometimes not-so-good), and it’s better to be prepared by having flexibility at your fingertips.”
Still, you can ask yourself some basic questions about your personal situation: Which federal tax bracket are you in today? Do you expect to be in a higher or lower one after you retire? Will your annual income increase or decrease? Although conventional wisdom suggests that gross income declines in retirement, taxable income sometimes does not. Think about it. You’ll be collecting (and owing taxes on) Social Security payments. You might opt to do some consulting or freelance work, on which you’ll have to pay self-employment tax. And once the kids are grown and you stop adding to the retirement nest egg, you lose some valuable tax deductions and tax credits. All this could leave you with higher taxable income, even after you stop working full-time.
Tax Deductions Vs. Tax Credits
A quick primer on tax deductions and tax credits:
A tax deduction is an item the government lets you write off of your taxes to lower your total taxable income. Deductions usually only apply if you itemize them, rather than taking the standard deduction (which is now $12,000 for single taxpayers and $24,000 for married taxpayers filing jointly, thanks to the Tax Cuts and Jobs Act passed at the end of 2017). Itemizing deductions is beneficial only if the total amount surpasses the sum for the relevant standard deduction you qualify for. Deductions basically get you a discount on the tax you pay. You don’t take a dollar off of taxes for every dollar spent; instead, every dollar that is deducted from your taxable income lowers the amount of income you will be taxed on. If you are in the 24% tax bracket, for example, every dollar you deduct gets a 24-cent tax break.
In contrast, a tax credit is a direct reduction of the amount of tax you owe. Common credits have been issued for spending money on green home improvements or for going back to school. No matter which credits you use, you are slashing your tax bill to the federal government: If you have $2,000 in tax credits, your taxes drop by $2,000. You can take credits whether you take a standard deduction or itemize deductions.
Tax credits are usually more elusive and not as easy to claim as tax deductions—but they are much better, because they always reduce your taxes. If you have the opportunity to take a $5,000 tax credit or a $5,000 tax deduction, the credit is the better deal. Say you have a tax bill of $10,000. The deduction would lower your taxable income by $5,000; so, if you were in the 24% tax bracket, your taxes would be reduced by $1,200 to $8,800. A credit would directly lower the tax due to $5,000, and that’s regardless of your bracket.
Comparing Roth and Traditional IRAs
This table lays out the differences between the two types of IRAs. Keep in mind that Congress can change these rules at any time. The regulations may be very different when you retire.
|2018 Contribution Limits||$5,500; $6,500, if age 50 or older||$5,500; $6,500, if age 50 or older|
|2018 Income Limits||Eligible are single tax filers with modified AGIs of less than $135,000 (phase-out begins at $120,000); married couples filing jointly with modified AGIs of less than $199,000 (phase-out begins at $189,000).||Anyone with earned income can contribute, but tax deductibility is based on income limits and participation in an employer plan.|
|Tax Treatment||No tax break for contributions; tax-free earnings and withdrawals in retirement.||Tax deduction in contribution year; ordinary income taxes owed on withdrawals.|
|Withdrawal Rule||Contributions can be withdrawn at any time, tax-free and penalty free. Five years after your first contribution and age 59½, earnings withdrawals are tax-free, too. No withdrawals required during account holder’s lifetime; beneficiaries can stretch distributions over many years.||Withdrawals are penalty free beginning at age 59½. Distributions must begin at age 70½; beneficiaries pay taxes on inherited IRAs.|
|Extra Benefits||After five years, up to $10,000 of earnings can be withdrawn penalty-free to cover first-time home-buyer expenses. Qualified education and hardship withdrawals may be available without penalty before the age limit and five-year waiting period. These may be taxed.||Contributions lower taxpayer’s AGI, potentially qualifying him or her for other tax incentives. Up to $10,000 penalty-free withdrawals to cover first-time home-buyer expenses, but taxes due on distributions. Qualified education and hardship withdrawals also available.|