Which IRA should you use: Traditional or Roth?
The two most popular types of IRA accounts are Traditional and Roth. This can be confusing for some investors. That’s because the two types of IRAs function comparably and accomplish much the same outcome. They can each be used to finance future retirement consumption goals. But there are subtle differences. And the few things that are unique to one or the other may offer you distinct advantages. Understanding the differences between the two may also help you use them in ways that aren’t obvious on the surface.
How Traditional IRAs Differ From Roth IRAs
The main difference between a Traditional IRA and a Roth IRA is how the flow of funds into and out of the account is treated. Contributions to a Traditional IRA may be tax deductible. Contributions to a Roth IRA are never tax deductible. In other words:
- a Traditional IRA is generally funded with pre-tax dollars
- a Roth IRA is funded with after-tax dollars
This affects how withdrawals from the two accounts are treated.
Qualified distributions (taken at age 59½ or older) from a Traditional IRA must be included in your taxable income the year you take them. Qualified distributions from a Roth IRA are never taxable.
Holding Periods and Mandatory Distributions
Another important distinction between a Traditional IRA and a Roth IRA is that there is a five year holding requirement for contributions made to a Roth IRA.
If you take a withdrawal from a Roth IRA – of funds that haven’t been in the account for five years – it won’t be considered a qualified distribution. It will be subject to an early withdrawal penalty. This is the case even if you are older than 59½.
Traditional IRAs have no holding requirement. The only thing that determines whether a distribution is qualified or not is your age. And age is important for another reason. At a certain point, you must start taking Required Minimum Distributions (RMDs) from your Traditional IRA.
Roth IRAs have no mandatory distributions for the original owner. You can keep funds in your Roth IRA throughout your entire life. There is no requirement that you ever withdraw them. But your heirs will be subject to the same RMD rules that govern an inherited Traditional IRA.
What Traditional and Roth IRAs Have in Common
The first thing that Traditional and Roth IRAs have in common is that beneficiaries who inherit them are subject to RMDs. This is the first similarity.
All IRAs allow you to save in a tax-advantaged way. The advantage is that income and growth are not subject to income taxes. That benefit exists for as long as funds remain in the IRA. And it applies equally to both Traditional and Roth IRAs.
Traditional and Roth IRAs Have The Same Contribution Limits
The two types of IRAs have the same aggregate contribution limits. For 2020 and 2021, you can contribute the smaller of:
- your total taxable compensation
- $6,000 if you are younger than 50 years old
- $7,000 if you are 50 or older
You can contribute to both a Traditional IRA and a Roth IRA. But the contribution limit ($6,000 or $7,000 – depending on your age) is the maximum total of what can go into all of your IRA accounts. Income and filing status may reduce contribution limits for both types of accounts.
There is no age limit on contributions for either type of IRA. You can make contributions to a Traditional or Roth IRA no matter how old you are.
Another way that Traditional and Roth IRAs are alike is how withdrawals are treated. You must be at least 59½ years old for a withdrawal to be considered a qualified distribution.
Early Distributions: Same Penalties and Same Exceptions
Distributions taken from a Traditional or Roth IRA before you reach 59½ years old are considered early withdrawals. They are generally subject to the early withdrawal penalty (noted earlier). That penalty is 10% of the distribution taken. But there are exceptions. They are the same for both types of IRAs.
Regardless of your age, any distributions taken from an IRA when you are totally and permanently disabled are not subject to the early withdrawal penalty. The same is true if you are a member of a reserve component and get called to active duty for more than 179 days (or an indefinite period). In neither case are distributions subject to a penalty.
Other distributions have limits to avoid the penalty. The following distributions can’t be greater than what is necessary to cover these expenses:
- unreimbursed medical expenses that exceed a set percentage of your adjusted gross income
- the cost of medical insurance when you become unemployed
- qualified higher education expenses
Another exception to the early withdrawal penalty applies if you buy, build, or rebuild a first home. The lifetime limit is $10,000 and funds must be used for yourself, your spouse, or certain close relatives.
Different IRAs Provide Different Financial Planning Opportunities
Both Traditional IRAs and Roth IRAs can play an important role in financing your future retirement consumption goals. They both allow you to contribute annually. And they both offer the ability to grow your investments in a tax-advantaged way. With proper planning they also offer considerable flexibility.
For example, a Roth IRA can be used to finance any consumption goal, even ones that precede retirement. Goals that might traditionally be financed using a taxable savings account are more efficiently financed using a Roth IRA. This is because income and growth in the Roth IRA are not taxed.
And just like a taxable savings account, when funds are ultimately withdrawn from a Roth IRA in a qualified distribution, there is no tax consequence.
Another planning opportunity arises for investors who use both types of IRAs to finance retirement. Coordinating withdrawals may help high-income retirees optimize Social Security benefits.
Some investors may benefit from delaying Social Security benefits until late in retirement (age 70 or older) and using their Traditional IRAs to provide taxable income early on. Then, delaying distributions from a Roth IRA may help them avoid taxes on their Social Security benefits. This is because those distributions won’t be taxable.
Regardless of which type of IRA you use, a critical question is how to invest the contributions you make. That’s where we can help. Our investment specialists are available to help you choose from a broad range of competitively priced, professionally managed products. Call us at 800.235.8396. Or contact us online.