Like other types of retirement accounts, Individual 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. The choice you make between these two types is 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 – have taxable income for tax year 2025, you can contribute up to $7,000 ($8,000 if you’re age 50 or older) to your IRAs. These contributions must be made before the tax filing deadline.
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
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. You typically 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.
Another important detail that you should consider is 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 you reach 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 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 if you don’t need to draw from retirement accounts to meet your income needs during retirement.
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. If you expect your tax rate to decline in the future, you may see more benefit from a Traditional IRA. Conversely, if you expect your tax bill to be higher in retirement, you 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 can help you determine which type of IRA to open. Our team of tax, legal, and investment professionals have been helping clients answer crucial retirement planning questions like this one for 40 years.
Our comprehensive financial plan, Financial Fingerprint®, brings together the most important aspects of your financial life into one easy-to-understand plan. This plan is easily adjusted to accommodate changing circumstances and goals throughout your life.
To learn more about Financial Fingerprint™ and get started today, contact us.
