Roth IRA vs. Traditional IRA: The Differences and When to Choose Each

It doesn’t matter how old you are; there’s no wrong time to start thinking about saving for your retirement. The most common way to do that for many people is to open an individual retirement account (IRA).

IRA accounts are versatile, but all of them are designed for making future investments. Even though you are already secured with your employee retirement plan, opening an IRA is always a wise choice. There are a few IRA account types to consider, but the most common ones are traditional and Roth IRAs.

Both types of IRA accounts are designed as savings accounts for retirement that bring some tax benefits to the taxpayers. No matter which one you choose, you will benefit somehow because either you will have tax-free withdrawals or benefit from tax-deductible contributions.

Also, all the prominent IRA companies offer both types of IRA accounts. The traditional IRA was founded in 1974, while the Roth IRA was established in 1997 by the Taxpayer Relief Act and named for its legislative sponsor, Senator William Roth. 

The Differences Between a Roth IRA and a Traditional IRA

Although both traditional and IRA accounts help you save for retirement, they are not equally suitable for all taxpayers, so knowing the differences between two account types will help you make your choice easier.

The first thing that differentiates the two account types is IRA taxes. With a traditional IRA account, you need to make a pre-tax contribution, while with Roth IRA, taxes are not deductible. However, you pay taxes on withdrawals later with a traditional IRA account, while with a Roth IRA, withdrawals are tax-free. We’ll explain it in more detail.

For traditional IRAs, you pay contributions that are tax-deductible on both stated and federal tax returns. One of the main advantages of traditional IRA accounts is that you can lower your tax liability for the year you make a contribution.

Your adjusted gross income (AGI) will be reduced so you can qualify for other tax benefits like child tax credits. However, with traditional IRAs, your withdrawals (distributions) will be calculated at the standard tax rate during your retirement.

When it comes to Roth IRA contributions, they are not tax-deductible when you make them. That means that your AGI won’t be lowered for that year. On the bright side, with a Roth IRA account, you will get tax-free withdrawals while in retirement.

In essence, it’s the opposite of a traditional IRA account, and what you pay for upfront saves you money later.

Another difference concerns income limits. For traditional IRA accounts, there are no eligibility requirements. Anyone who has an earned income qualifies for a traditional IRA, but different factors can determine if the contribution is fully tax-deductible. For example, the IRS will check whether you have a pension plan provided by your employer (401(k)).  

Roth IRA works a bit differently. There are income limits for it based on the so-called Modified Adjusted Gross Income (MAGI). MAGI is calculated from your Adjusted Gross Income (AGI) + several deductions and exclusions, such as the student loan interest deduction and the excluded employer adoption benefits. 

If you want to enjoy Roth IRA benefits, the income limit is $6,000, or $7,000. Singles must have a MAGI lower than $140,000, and the contributions start getting phased out at $125,000. For married couples, MAGI must be less than $208,000, while the phase-out begins at $198,000.

For 2021, MAGI for singles must be less than $140,000, with contributions start being reduced with a MAGI of $125,000. For married couples, MAGO has to be less than $208,000, and the deductions are reduced starting at $198,000.

The next big difference lies in money distribution. With both traditional and Roth accounts, the funds must be transferred to the owner’s account eventually. If you have a traditional IRA account, you must take the required minimum distributions (RMDs) after turning 72.

But, if you have a Roth IRA account, you are not required to withdraw funds after reaching a certain age. In fact, you don’t need to take the money during your lifetime at all so that you can pass the entire balance to your beneficiaries.

Another important thing to mention is that there are no taxes on Roth IRA distributions from inherited accounts, which is great for your beneficiaries.

If you want to get money from your traditional IRA account before the age of 60 (59½, to be precise), you will have traditional IRA tax responsibilities, and you’ll need to pay early withdrawal penalties. The penalty is 10%, but in some circumstances, you can avoid it.

For example, if you withdraw funds for education expenses (tuition, fees, and other expenses) or medical ones, you can avoid paying the penalties. On the other hand, you can withdraw contributions from your Roth IRA account at any time you want without paying withdrawal penalties or taxes. 

However, the benefits are not the same when you want to withdraw your earnings, meaning that you’ll need to pay taxes or early withdrawal penalties unless you meet certain criteria. Roth IRA and taxes can be tricky in this regard, and you must meet one or more of the following criteria:  

• Be at least 59 ½ years old
• Have a Roth IRA account with at least five years worth of contributions
• Have a permanent disability
• Want to use the money to buy a house for the first time (up to $10,000 of your contributed earnings can be withdrawn penalty-free)

As you can see, Roth IRA’s advantages are mostly the tax-free contribution withdrawals for you and your heirs. Still, until you meet the above criteria, you’ll need exceptional circumstances (for example, facing extreme financial hardship) to be allowed to take earnings withdrawals out of your Roth IRA account early.