When it comes to financial planning, saving for retirement is a top priority. When we picture our golden years, we hope to be able to enjoy financial freedom, live comfortably, and perhaps even provide for others after we’re gone. One of the most popular vehicles for people with earned income to save for retirement is an Individual Retirement Account (IRA), which is a tax-advantaged savings account. When opening an IRA, you’ll need to choose between two main types: a traditional IRA or a Roth IRA. Learn more about these options so that you can choose the best type of IRA for your unique circumstances.
Traditional vs Roth IRA Key Takeaways
- The key difference between traditional and Roth IRAs lies in the timing of tax advantages:
- Traditional IRA: Deduct contributions now and pay taxes on withdrawals later. Earnings are taxed when distributed.
- Roth IRAs: Pay taxes on contributions now and get tax-free withdrawals later. Earnings on qualified distributions are not taxed.
- Both accounts have rules about the amounts you can contribute each year, based on your income and age.
- Roth IRAs have fewer restrictions, but they also offer fewer tax breaks today.
- Choosing between a traditional IRA and a Roth IRA depends on whether you think your annual income and tax bracket will be higher or lower in retirement than it is now.
Traditional vs Roth IRAs: What’s the difference?
Both traditional and Roth IRAs provide generous tax breaks, but the key difference is when you can claim them. Contributions to Roth IRAs are not tax-deductible, but qualified retirement withdrawals are tax-free. In comparison, contributions to traditional IRAs are tax-deductible, but withdrawals in retirement are taxable.
Quick comparison: Traditional IRAs vs Roth IRAs
|Rule||Traditional IRA||Roth IRA|
|2022 contribution limits||$6,000$7,000 for ages 50+||$6,000$7,000 for ages 50+|
|2022 income limits||No income limit for taxpayers with earned income and not covered by a workplace retirement plan|
$68,000 to $78,000 – Single taxpayers covered by a workplace retirement plan
$109,000 to $129,000 – Married couples filing jointly. This applies when the spouse making the IRA contribution is covered by a workplace retirement plan
$204,000 to $214,000 – A taxpayer not covered by a workplace retirement plan married to someone who’s covered
$0 to $10,000 – Married filing a separate return and covered by a workplace retirement plan
|$129,000 to $144,000 – Single taxpayers and heads of household|
$204,000 to $214,000 – Married, filing jointly
$0 to $10,000 – Married, filing separately
|Tax credit||Eligible for savers tax credit.||Eligible for savers tax credit.|
|Tax treatment||Contributions: tax-deductible|
Withdrawals and earnings in retirement: Taxed as ordinary income
|Contributions: no tax deduction|
Withdrawals and earnings in retirement: Tax-free
|Withdrawals||Penalty-free beginning at age 59½.||Contributions can be withdrawn at any time, tax-free and penalty-free.|
Earnings withdrawals are tax-free after meeting five-year rule and age 59½.
|Required minimum distribution||Account owner distributions must begin at age 72.||None for account owners.|
|Account beneficiaries||Subject to RMD rules.||Subject to RMD rules.|
|Homebuyer benefit||Up to $10,000 in penalty-free withdrawals to cover first-time homebuyer expenses.||Contributions can be withdrawn tax-free.|
Earnings can be tapped up to $10,000 in penalty-free withdrawals to cover first-time homebuyer expenses, provided you’ve held the account for at least five years.
|Education withdrawals||Can be withdrawn without penalty with proof of enrollment.||Contributions can be withdrawn tax-free. Earnings may be taxable but not penalized.|
|Hardship withdrawals||Available in certain situations.||Available without penalty before the five-year waiting period and age limit.|
How to choose between a traditional and Roth IRA
Most advice on the Roth IRA vs traditional IRA topic concerns whether you think your future income (and thus your tax rate) will be higher or lower in the future. If you have a definitive answer to this question, you can, in theory, choose the type of IRA that will give you the biggest tax savings.
- If you expect to be in a higher tax bracket in retirement, it could be beneficial to choose a Roth IRA and its delayed tax benefit.
- If you expect lower tax rates in retirement, choose a traditional IRA for its upfront tax advantage.
However, it’s not always straightforward to anticipate what your tax rate will be in retirement, so it’s important to consider other factors to determine which type of IRA is best for you.
Don’t assume that income decreases in retirement
Conventional wisdom may suggest that gross income will decline in retirement, but remember that taxable income sometimes does not. Here’s why:
- You’ll be collecting Social Security benefits and possibly owing taxes on them.
- You may have income from investments.
- You could opt to do some freelance work.
- You may lose some valuable tax deductions and tax credits when the kids have left home and you stop contributing to your retirement nest egg.
So, even if you stop working full time, you could potentially get higher taxable income.
Check your eligibility
Your income will determine if you’re eligible to contribute to a Roth IRA. You are ineligible to contribute to a Roth IRA if you are single and make over $144,000, or married and make over $214,000, in 2022.
Traditional IRA deductibility is only restricted if you or your spouse has access to a workplace savings plan like a 401(k).
Consider your age
The younger you are, the more you stand to benefit from a Roth IRA. In fact, we recommend opening one as soon as you have earned income. While a teenager may not be ready to think about retirement, it’s tough to ignore the many decades available for the contributions to grow. Remember, all earnings in a Roth IRA are tax free. Even a small contribution will grow significantly over the decades.
5 Reasons to choose a Roth IRA
- More flexible withdrawal rules.
- Fewer restrictions for retirees.
- Because your tax break doesn’t arrive until retirement, you may be less tempted to spend the funds before then.
- Funding a Roth in conjunction with a 401(k) (which has the same tax benefits as a traditional IRA) provides tax diversification.
- Can serve as backup savings for other needs.
In general, a Roth IRA can work well if you’re at least 15 years away from retirement and you want to prepay taxes (at a lower rate), then withdraw funds tax-free in retirement when you’re in a higher tax bracket.
The main reason to choose a traditional IRA
If you don’t qualify for a Roth IRA due to income restrictions, a traditional IRA is your only option. It could also be the better choice if you expect to be in a lower tax bracket during retirement. Another advantage of a traditional IRA is the upfront tax break, which can be a huge advantage for high earners. It’s also a great incentive for people who might otherwise skip saving for retirement. Effectively, a traditional IRA makes it cheaper to save for retirement in the short term since the tax savings each year reduce the cost of contributions. However, you’ll have to face that tax burden in retirement.
Can I contribute to both types of IRAs?
Assuming you’re eligible for both, you can own and contribute to a traditional IRA and a Roth IRA and hedge your tax situation. However, your total deposits in all accounts must not exceed the maximum IRA contribution limit for that tax year—$6,000, or $7,000 if you are 50 or older.
Get a trusted advisor on your side
Navigating retirement savings options on your own can be overwhelming. A financial advisor has the expertise to ensure that you get the most out of your retirement years. At Financial Solution Advisors, we emphasize that retirement saving should always be a top priority, and we’re here to help you find the right products for your specific situation. Please reach out to us to schedule a retirement planning meeting with one of our professionals.