Traditional Vs Roth IRA

School of Saving and Investing

Retirement savings through Traditional and Roth IRAs depicted by an elderly couple standing on a stack of coins.

An Individual Retirement Account [IRA] could help you reach your retirement goals faster while maintaining control of your investments. Like other types of retirement accounts, IRAs are designed to encourage workers to save more for retirement by providing significant tax advantages. However, the impact and timing of tax benefits depend on the type of IRA you choose.

There are two main types of IRAs – Traditional and Roth. Choosing the one that matches your situation can be essential to maximizing your tax savings and retirement income. To determine which type of IRA works for you, first understand the similarities and key differences between Traditional and Roth IRAs.

Similarities Between Traditional IRAs and Roth IRAs

IRAs – both Traditional and Roth – are individually owned. This means they aren’t tied to your employer or any other group. One benefit of individual ownership is you aren’t limited to a select list of investments chosen by your employer. Instead, you can invest the funds in your IRA as you see fit, with a few exceptions (like property and collectibles). Another benefit of individual ownership is you can access the funds in an IRA at any time, even before retirement. However, use caution because penalties often apply for early withdrawals.

Both Traditional and Roth IRAs have the same contribution limits and are subject to the same timeline for contributions. If you (or your spouse if you are married filing jointly) had taxable income for tax year 2023, you can contribute up to $6,500 ($7,500 if you’re age 50 or older) to your IRAs. These contributions must be made before the tax filing deadline of the following year.

Differences Between Traditional IRAs and Roth IRAs

While Traditional and Roth IRAs have some similarities, they also have key differences that you should understand. The main differences are how contributions and withdrawals are taxed and the requirements for when you must take distributions from your account.

Traditional IRAs Can Provide Immediate Tax Benefits

Annual contributions to a Traditional IRA are often tax deductible. However, the amount of Traditional IRA contributions you can deduct depends on your income, filing status, and employer retirement benefits.

Since Traditional IRA tax benefits are usually realized when you contribute, you will likely owe tax when you withdraw your funds during retirement. With a Traditional IRA, you pay income tax on the entire amount you withdraw – both your original contributions and the accumulated earnings.

As previously mentioned, you can withdraw funds from an IRA for any reason, at any time. However, if you withdraw funds from a Traditional IRA before age 59 ½, you could owe a 10% early withdrawal penalty in addition to income tax. There are certain instances where the penalty is waived, such as using the funds to pay for a first-time home purchase, qualified medical expenses, or qualified education expenses.

Roth IRAs Typically Provide Delayed Tax Benefits

Unlike a Traditional IRA, contributions to a Roth IRA are not tax deductible, so this type of account doesn’t save you money in the current year. Instead, the tax benefits of a Roth IRA are realized when you begin taking distributions.

Since you already paid tax on your contributions in the year you made them, you don’t owe tax on those funds when you withdraw them – either before or after retirement. That means that you can take out your contributions at any time, tax and penalty free. Additionally, if you are over age 59 ½ and have maintained a Roth IRA for more than 5 years when you take a distribution, you typically don’t owe tax on earnings. However, if you withdraw funds from a Roth IRA before age 59 ½, you could owe tax and a 10% penalty on the earnings. The same waivers apply to this penalty as with Traditional IRAs.

It is also important to note that you can only contribute directly to a Roth IRA if your income is below certain limits. If your income is above the limits, you may still be able to add money to a Roth IRA with a backdoor Roth contribution. However, there are important caveats to using this strategy, so be sure to discuss it with an experienced financial advisor before you implement it.

Traditional IRAs are Subject to Required Minimum Distributions

Traditional IRAs are subject to Required Minimum Distributions [RMDs]. These are annual withdrawals you must make once reaching a certain age. The SECURE Act 2.0 raised the RMD age from 72 to 73 for those who turn 73 in 2023 or later. In 2033, the RMD age will be further increased to age 75.

Roth IRAs are Not Subject to Required Minimum Distributions

Unlike Traditional IRAs, Roth IRAs are not subject to RMDs during your lifetime. This can be a significant advantage for those who don’t need to draw from their retirement accounts to meet their income needs during retirement.

Traditional and Roth IRA features compared in a chart.

To summarize, Traditional IRAs defer tax until retirement and are subject to RMDs. On the other hand, Roth IRAs do not provide an immediate tax advantage but can reduce the tax you owe in retirement. Now, the question becomes ­– which type of IRA matches your situation?

Choosing Between a Traditional IRA and Roth IRA

When deciding between a Traditional and Roth IRA, there are many factors to consider but the decision typically comes down to the tax benefits. Those who expect their tax rate to decline in the future may see more benefit from a Traditional IRA. Conversely, those who expect their tax bill to be higher in retirement may prefer a Roth IRA.

Another factor that can impact the decision between a Traditional and Roth IRA is the amount of earnings you anticipate. If you have a short time horizon, or tend to take lower risk with your investments, you may prefer a Traditional IRA. That’s because you would expect to have lower earnings, so paying tax on investment growth in retirement would be less of a burden. Conversely, if you have many years until retirement, or invest aggressively, you may anticipate a high amount of accumulated earnings. In this situation, a Roth IRA may provide a greater benefit since earnings are not taxed when you make qualified withdrawals.

The decision between a Traditional and Roth IRA depends heavily on your current and future tax situation, and your overall financial plan. Before you decide which type of account to open, discuss these factors with an experienced financial advisor. An advisor can help you forecast your taxes, estimate your earnings, and determine which type of account would be more advantageous in your situation.

Plan for A Successful Retirement with Meld Financial

At Meld Financial, we have been helping clients achieve their retirement dreams for nearly 40 years. Our team of tax, legal, and investment professionals has the experience to answer your most pressing retirement questions – like which type of IRA to open.

Our comprehensive financial plan, Financial Fingerprint™, is quick to assemble, easy to understand, and simple to modify as your circumstances change. This plan accounts for the most important aspects of your financial life from setting actionable goals to determining how to invest your savings to achieve retirement success.

To learn more about Financial Fingerprint™ and get started today, contact us.

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