Traditional vs. Roth IRA
By Sean C. Mahoney, CFP®
According to the Investment Company Institute (as of May 2020), roughly 36.1 million U.S. households own a Traditional Individual Retirement Account (IRA) compared with Roth IRAs which are owned by nearly 24.9 million households.
The point of each account is the same – build up a nest egg for you when you retire from the workforce. Each account is used as an individual retirement account so what’s the difference between the two and which do YOU need? Let’s examine a few of the differences.
How will you pay the IRS taxes?
If you elect a traditional IRA account, you will pay taxes on your withdrawals from your account later, presumably in retirement. Generally, traditional IRAs help to lower your taxable income during the year you contribute to your IRA. In return for these tax breaks, your account is more restricted on when you can access your funds. We will get to this later…
A Roth IRA is set up to be the opposite. You don’t receive any tax deductions when you contribute to your Roth. Instead, think of it like you are paying your taxes today on your contributions (since they are after tax) and receiving tax-free withdrawals later on all the money in your account. A Roth IRA’s tax structure is like buying a gift card to a restaurant. When you buy the gift card, you have already paid for the meal or in the case of the Roth IRA, you have already paid the taxes. When you visit the restaurant for your meal, you leave without pulling out your credit card to pay because you paid on a previous day.
When do you need to access your funds?
Another difference between the two accounts are the rules around when you can take a distribution. A traditional IRA requires a minimum distribution once you reach 72 years old whether you want to begin withdrawals or not. A Roth IRA does not require minimum distributions during your lifetime.
Do you receive penalties for early withdrawals?
Lastly, the third largest difference between the two accounts are the penalties for pre-retirement withdrawals. If you have to withdrawal from a traditional IRA before the age of 59 ½ for almost any reason (there are a few exceptions), you will have to pay income taxes and a 10% early withdrawal penalty.
In contrast, if you need to withdraw money from your Roth IRA account, you can withdraw sums equivalent to your contributions at any time before the age of 59 ½. However, keep in mind, if you need to withdraw earnings on a Roth before reaching the age of 59 ½, you may be required to pay early withdrawal penalties unless you qualify for certain exemptions.
The main question to ask yourself and discuss with your financial advisor is if you think your annual income and your tax bracket will be lower or higher in retirement? Depending on your current financial situation and your expected post-retirement financial situation, you may need a traditional IRA, a Roth IRA or both types of accounts may be needed. Understanding the differences between the accounts is crucial when picking which account will best serve your needs.
The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation.