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What are the Differences between a Traditional IRA and a Roth IRA?

IRA, 401k, and Roth written on a sheet of note paper, surrounded by money and a calculator
February 22 2019 • by Andrea Rodrigues • Money Management, Retirement

If you’re contributing to a 401(k) at work and you find yourself maxing out on the amount you can contribute annually, or if you’re not eligible for an employer-sponsored 401(k) plan, you luckily have another option to help build up your retirement savings – an IRA.

An IRA, or Individual Retirement Account, is an account offered by a financial institution that allows you to save for retirement on a tax-deferred basis (with a Traditional IRA), or with tax-free growth (with a Roth IRA). But what exactly are the differences between Traditional and Roth IRAs?

Traditional IRAs

A Traditional IRA is designed to leave more after-tax dollars for your retirement. You save money now, but the money you earn on those contributions is not taxed until you begin making withdrawals from the account in retirement, when you'll likely be in a lower tax bracket. Any income-earning individual can contribute to a Traditional IRA as long as they will not reach 70 ½ years of age by the end of the year in which they contribute.

Those under age 50 can contribute up to $6,000 per year to a Traditional IRA. For those 50 and older, the contribution limit is $7,000 to allow for "catch-up" contributions.

Even if you participate in an employer-sponsored retirement plan such as a 401(k), you are still eligible to open a Traditional IRA.

Contributions made to a Traditional IRA are tax deductible on both state and federal tax returns for the year in which the contribution is made, however if you or your spouse are also covered by a work-sponsored retirement plan, your deduction may be limited.

It’s important to note that in most cases, there is a 10% tax on any withdrawals you make from a Traditional IRA before the age of 59 ½. There are certain circumstances however where withdrawing your funds early will not result in a penalty.

Another thing to consider with a Traditional IRA, is that you will be forced to start taking required minimum distributions from the account once you reach the age of 70 ½.

Roth IRAs

While a Traditional IRA is funded with “pre-tax” dollars (in other words, money that has not yet been taxed), a Roth IRA is funded with “after tax” dollars. This means that you pay taxes on the money before you place it in your Roth IRA. As a result, the funds in your Roth IRA grow tax-free. There are no tax payments to be made when you withdraw the money in retirement.

Like a Traditional IRA, the maximum amount that you can contribute to a Roth IRA for the 2019 tax year is $6,000 (or $7,000 if you’re age 50 or older).

You can withdraw your contributions from a Roth IRA at any time without penalty, but it’s important to note that you will likely be penalized for withdrawing any investment earnings before age 59 ½. There are income limits for Roth IRAs as well, so if you make upwards of $122,000 annually you could have your contribution limit reduced, or you could be ineligible for contributions altogether depending on your tax filing status and exact income level.

Unlike a Traditional IRA, there are no required minimum distributions with a Roth IRA, even after you reach age 70 ½. This can be beneficial for someone who wishes to continue working into their seventies without touching their retirement savings. With a Roth IRA, you can also continue making contributions to the account if you’re past the age of 70 ½ (as long as your income doesn’t exceed the established Roth IRA income limits). This is in contrast to a Traditional IRA, which does not allow contributions from individuals who will reach 70 ½ years of age by the end of the year in which they’re contributing.

If you currently have a Traditional IRA but determine that a Roth IRA is a better fit for you, you can always convert your account to a Roth IRA. You will generally have to pay income taxes on the contributions that you move over, but you won’t have to pay taxes on the earnings that you move over).

Deciding which is right for you

Ultimately, the determination of whether a Traditional or Roth IRA is the right fit for you will depend on your age, your income level, your retirement goals, and your own unique financial situation. It’s always a good idea to consult with a financial planner, investment executive, and/or a tax advisor before making any major investment decisions.