Should I Contribute to a Roth or a Traditional IRA?

Have you ever experienced confusion or frustration when it comes to understanding finance or retirement planning terms? Maybe you’ve heard the words “Traditional” and “Roth” in the context of IRAs or 401(k)s.  But do you know how to distinguish between the two? Or do you know which is better suited to your needs? Should you contribute to a Roth or a Traditional IRA? Let’s compare the key features of both types of accounts.

Similarities between Roth IRAs and Traditional IRAs

We will start by addressing the similarities between Traditional IRAs and Roth IRAs. They are both major types of retirement savings plans. You can contribute to an IRA if you have at least as much taxable compensation as the amount of your IRA contribution. The 2020 contribution limits for both types are $6,000, or $7,000 if you are age 50 and older. If you are married filing jointly, your spouse can also contribute to an IRA, even if they have little or no taxable income, as long as your joint income is at least equal to your total contributions.

Both of these accounts allow for tax-sheltered growth of earnings and have a wide choice of investment options. While there are some similarities, understanding the differences is key when determining which plan works best for you personally.

Differences between Roth IRAs and Traditional IRAs

The key difference in Roth and Traditional IRAs is how they are funded. Roth IRAs are funded with after-tax dollars, and Traditional IRAs are funded with pre-tax dollars. That means your contributions to a Traditional IRA are tax deductible on your federal income tax return in the year they are made.  Those contributions and the earnings within the account are taxed when you withdraw them during retirement. For Roth IRAs, contributions are made with after-tax dollars (and are not tax deductible).  As long as a few conditions are met, withdrawals of both contributions and earnings are tax-free.

Key Features of Roth IRAs

While most people are eligible to contribute to a Traditional IRA, Roth IRAs have slightly different requirements. To be able to contribute to a Roth IRA, you have to meet certain MAGI (Modified Adjusted Gross Income) levels. The levels are as follows:

For single or head of household filers, if your MAGI is $124,000 or less, you can contribute the full $6,000 to your Roth IRA each year. However, if your MAGI is above that, there is a phase-out. This means your contribution limit is reduced. If your MAGI is $139,000 or more, you are not eligible to contribute to a Roth IRA. For married filing jointly filers, the phase-out begins at joint MAGI of $196,000, and eligibility ends at $206,000.

You can check out the IRS link below for more details of the requirements for Roth IRA contributions:

As I mentioned before, there are a few conditions that need to be met in order for Roth IRA distributions to be tax-free at withdrawal. The account must be open for five years before tax-free distributions can take place.  In addition to that requirement, distributions from your Roth IRA are tax-free if one of the following applies:

  • You are at least age 59 ½ at the time of withdrawal.
  • The withdrawal is made because of a disability.
  • You are withdrawing funds for first time homebuyer expenses.
  • The withdrawal is made by a beneficiary after your death.

If you are younger than 59 ½ and none of the other criteria are met, you will be subject to a 10% penalty on the funds you withdraw. However, if you do make a nonqualified distribution, only the earnings portion of the distribution will be taxed.

Required minimum distributions do not apply to Roth IRAs.  You are never required to take a distribution from a Roth IRA.

Key Features of Traditional IRAs

As we discussed previously, most everyone is eligible to contribute to a Traditional IRA.  Contributions to Traditional IRAs are tax deductible, which means they lower your taxable income in the year they are made. There are no phase-outs for those with higher MAGI as there are with Roth IRA contributions unless either you or your spouse is covered by an employer sponsored retirement plan, like a 401(k). If neither you nor your spouse is covered by an employer retirement plan, you can deduct the full amount on your tax return up to the contribution limit. However, if one of you is covered by an employer plan, your MAGI determines how much of your IRA contribution is deductible. You can read more about those rules here:

Keep in mind that once you reach age 72, you must take a required minimum distribution each year from your IRA, even if you don’t necessarily need it at the time. The initial distribution will be between 3% and 4% of the IRA’s value.

Should I Contribute to a Roth or a Traditional IRA?

The answer to this question is different for everyone. Assuming you are eligible for both types of accounts, it might make sense to utilize the features of a Roth IRA if you anticipate the need for tax relief later in life, rather than now. Maybe you are just starting out in your career and in a lower tax bracket. It could make more sense to pay the tax on contributions now to enable tax-free withdrawals later, when you’ll potentially be in a higher tax bracket. However, if the opposite is true, and you anticipate being in a lower tax bracket during retirement than you’re in now, the Traditional IRA approach might suit you better. That way you get the tax deduction now, when it is more valuable to you.  Then you pay taxes on withdrawals during retirement, when you are in a lower tax bracket.

The bottom line is that retirement plans are not one-size-fits-all. If you’re not sure about which path you should take to get started saving for retirement, and you’re not eligible for an employer-sponsored retirement plan, it might be advantageous to talk to a financial planner or tax advisor to help you get started.

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Any opinions are those of Hannah Bartlett and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notices.