ROTH IRAs vs. TRADITIONAL IRAs
When it comes to saving for retirement, the major question is Roth IRA vs Traditional IRA…what’s the difference? This blog will teach you all the similarities and differences of Roth IRA vs Traditional IRA, and help you figure out which one is best for you.
Pros & Cons of Roth IRAs
- Tax free distributions, if over 59 1/2
- No Required Minimum Distributions (RMDs)
- Tax-free inheritance for heirs
- Can withdraw contributions tax & penalty free if < 59 1/2
- Can withdraw up to $10k tax & penalty free for college/buying a house for the first time if < 59 1/2
- No tax write-off for contributions
- Pay tax + 10% penalty on non-exception distributions
- Can’t contribute if income over a certain amount
- No guarantee government won’t change the rules and start taxing in future
- Traditional IRA generally better if taxes end up being lower in retirement
Pros & Cons of Traditional IRAs
- Tax deduction for contributions
- No income limits; anyone w/ earned income can contribute
- If RMD age, can avoid tax on withdrawals by sending RMD straight to a qualified charity (called a “Qualified Charitable Distribution“)
- Generally better than Roth if tax rates are lower in retirement
- Only get tax deduction if income under certain amounts
- Mandatory Required Minimum Distributions (RMDs) starting at 72, even if you don’t need the money
- Generally, all withdrawals are taxed (even withdrawals of contributions)
- If tax rates are higher in retirement, would’ve been better off with a Roth
SIMILARITIES BETWEEN ROTH IRAs and TRADITIONAL IRAs
Roth IRAs and Traditional IRAs are both ways to save for retirement. There are two basic similarities.
1. No taxes on investment gains, dividends, and interest
The main similarity is that both accounts allow you to avoid paying tax on any gains, interest, and dividends earned within the account year-in-and-year-out.
For example, if you buy $100 of stock in a regular/non-IRA investment account and then eventually sell the stock for $150, you will pay capital gains tax on the $50 difference. The same goes for any interest and dividends earned each year within the account.
If you instead bought $100 of stock inside a Traditional or Roth IRA and then eventually sold it for $150, you would pay nothing. Same for interest and dividends.
Now stretch that out over years and decades of investing and you can see how using an IRA is a no-brainer when it comes to saving for retirement. The government wants to incentivize people to save for retirement, so they give IRAs special rules to make retirement saving more attractive.
2. Contribution limits
Roth IRAs and Traditional IRAs have the same annual contribution limits. This year (2020) the limit is $6,000 per person. If you are over 50 you can put in an extra $1,000, for a total of $7,000. The IRS usually increases the limits each year.
Note, the limit is across the board for all IRAs. You cannot contribute $6,000 to a Traditional IRA and $6,000 to a Roth IRA the same year. You are allowed to contribute to both, it’s just that the combined total across all IRAs cannot be more than $6,000 (or $7,000 if over 50).
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DIFFERENCES BETWEEN ROTH IRAs AND TRADITIONAL IRAs
Traditional and Roth IRAs are more different than they are similar.
1. Tax deductions
With Traditional IRAs you can generally take a tax deduction each year for whatever dollar amount you contribute (see if you can deduct your Traditional IRA contributions). For example, if your income is $50,000 and you contribute $5,000 to a Traditional IRA, you would only be taxed on $45,000 of income. If your tax bracket is 22%, that saves $1,100 in taxes ($5,000 x 22%).
There is no upfront tax deduction for Roth IRA contributions. In the above example if you had instead contributed $5,000 to a Roth IRA you’d still pay taxes on the full $50,000 of income.
2. Taxes on withdrawals
Traditional IRAs defer taxes to the future. That is, you eventually pay taxes when you take money out of the account. Those withdrawals are treated as taxable income and taxed at the same rate as income like salary and wages (see this table for 2020 tax rates)
On the other hand you generally do not have to pay taxes on Roth IRA withdrawals. Roth IRAs fast-forward the tax implications to present day because you don’t get a tax deduction for contributions. In other words, your contributions are made with after-tax dollars, or money that has already been taxed once by the IRS (i.e. payroll taxes, etc.). You’ve paid the tax already, so later on down the road you aren’t taxed again when you take money out of the account.
Note – not all Roth IRA withdrawals are tax free. You might pay tax + a 10% penalty if you don’t meet certain requirements. Download this guide to learn more about taxes & penalties on Roth IRAs.
3. Required Minimum Distributions ('RMDs')
If you’re retired or nearing retirement, you’ve likely heard of ‘Required Minimum Distributions”, or RMDs.
RMDs are mandatory withdrawals you have to take from Traditional IRAs and other retirement accounts starting at age 72.
But do you have to take RMDs from Roth IRAs? The answer is no!
Traditional IRAs have to take Required Minimum distributions, but Roth IRAs do not. Because an RMD is a withdrawal, you have to pay tax on RMDs from Traditional IRAs even if you didn’t need the money.
Only taxpayers under certain income limits can contribute to Roth IRAs.
On the other hand anyone with earned income (i.e. wages, self-employment, etc.) can contribute to a Traditional IRA. However, not everyone qualifies for a tax deduction. Check the income limits on who can deduct Traditional IRA contributions. If you don’t qualify for the deduction, you can still contribute to a Traditional IRA. Your money will grow tax free, but you still have to pay tax on any withdrawals down the road, which begs the question of whether it makes sense to make non-deductible Traditional IRA contributions (in some cases, it does).
Should I Do a Traditional IRA or a Roth IRA?
The question you’re probably asking yourself now is “should I do a Traditional IRA or Roth IRA?”. Based off everything above, it sounds like doing a Roth IRA is a no-brainer. In reality, the answer is not so simple.
Generally, if you expect taxes to be HIGHER in the future then it makes more sense to do a Roth IRA. This would either be your own personal tax bracket, or tax rates in general. Why? Well if you think taxes will be higher in the future, then that implies you have a lower tax rate today. A lower tax rate today means you don’t get as much benefit from a current year tax-write off (I.e. a Traditional IRA contribution) as you would having tax free income in the future when taxes are higher. In other words, you’d be ok not getting a tax break today, in order to save the tax break for the future.
If you expect taxes to be LOWER in the future then a Traditional IRA often makes more sense. Why? A low tax rate in the future implies that your taxes are higher today. If your tax rate is higher today, then you’d stand to benefit more from getting a tax deduction this year. In other words, you want the tax break today, and are ok paying taxes on IRA distributions in the future when you think your personal tax rate or tax rates in general will be lower.
Here’s a helpful flowchart to help you make your decision between a Traditional IRA vs. a Roth IRA.
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