Traditional IRA vs. Roth IRA: Which is Right for You?

Oct 21, 2015

Traditional IRA vs. Roth IRA: Which is Right for You?

IRAs are a key part of most solid retirement plans, the rich tax benefits being one of the most attractive features. However, the tax deductions change depending on which kind of IRA you select. If you’re trying to decide whether to contribute to a traditional IRA vs. a Roth IRA, it’s important to understand the differences between these two types of savings accounts.

Traditional Ira vs. Roth Ira: The Traditional

The biggest separating factor in traditional IRAs vs. Roth IRAs is whether or not your contributions are tax deductible. Deposits to a traditional IRA are deductible, meaning not taxed (depending on a few factors like tax filing status, and eligibility to participate in a tax-qualified retirement plan through your employer).  Regardless, whatever you earn on your contributions won’t be taxed until you withdraw it years later.

So, for instance, if you make $100,000 in a year, and contribute $5,000 of it to an IRA, you will only pay income tax on $95,000. That deposit will now grow tax-free until you withdraw it in retirement (after age 59 ½). At that point the money will be taxed at your ordinary income tax rate. If you withdraw before 59 ½, you will usually have to pay both the taxes and a 10% penalty fee on whatever the funds have earned—there are exceptions to this depending on circumstances, such as using the money for higher education (see table below).

Eight Exceptions to the Penalty for Early IRA Withdrawal

  1. Withdrawal due to the IRA owner's disability
  2. Withdrawal due to the IRA owner's death
  3. Paid out as a series of "substantially equal periodic payments" made over the life expectancy of the IRA owner
  4. Money is used to pay for unreimbursed medical expenses over 7 1/2% of adjusted gross income
  5. Money is used to pay medical insurance premiums after the IRA owner has gotten unemployment compensation for over 12 weeks
  6. Money is used to pay the costs of a first-time home purchase (has a lifetime limit of $10,000)
  7. Money is used to pay for the qualified expenses of higher education for the IRA owner and/or eligible family members
  8. Money is used to pay back taxes because of an Internal Revenue Service levy placed against the IRA

Another differentiating factor is that with a traditional IRA, you must start taking mandatory withdrawals once you reach 70 ½. This is not the case for Roth IRAs. Of course, you may take more than the minimum out, but the IRS has a set of required minimum distributions you must follow to avoid penalties.

Traditional Ira vs. Roth Ira: The Roth

The tax structure for the Roth IRA is different, as your contributions are not deductible. So, using the same example, you would still be taxed on $100,000, even though you put $5,000 of it into a Roth IRA. But, assuming you have the account for at least five years and are older than 59 ½, you aren’t taxed on anything when you withdraw the money from a Roth IRA—including the earnings. Yes, you get off completely tax-free!

For this reason, Roth IRA’s are considered tax-exempt rather than tax-deferred savings. Both allow you to save for the future but, again, with a Roth IRA you never pay taxes on your gains. This is often a far better choice than simply taking the deduction upon contribution.

Another difference between traditional IRAs vs. Roth IRAs is restrictions on who can contribute. Whereas anyone younger that 70 ½ can contribute to a traditional IRA, Roth IRA’s have income-eligibility restrictions. For example, single tax filers need to have a modified adjusted gross income of less than $114,000 to fully contribute to a Roth IRA, and for married couples filing jointly, eligibility requirements dictate that reported income must be no higher than $181,000.

Traditional Ira vs. Roth Ira: Which is Right For You?

If you have funds to put away for retirement and are trying to decide where to put them: in a traditional IRA vs. Roth IRA, most financial advisors will suggest that the Roth IRA is the better choice. With a Roth, not only do you avoid mandatory withdrawals, but you also get to earn income that is completely tax-free. There is a lot of flexibility there. However, you need to be sure that you meet the income requirements stated above, will be able to leave the money in the account at least five years, and won’t need it until after 59 ½ (excluding the eight penalty exceptions listed above).

Traditional Ira vs. Roth Ira: Should You Convert?

If you already have funds in a traditional IRA, it may be prudent to convert it into a Roth. You will have to pay taxes on the old IRA, but there will be no penalty for early withdrawal. If you’ll need to dip into your IRA savings to pay these taxes, the sacrifice on your principal may be too big to make the conversion worthwhile. That said, if you have many years to make up for the cut into your savings it might make sense. Also, note that monies rolled over into a Roth IRA have greater restrictions for penalty-free and tax-free distributions than normal Roth IRA contributions do.