A Roth IRA vs Traditional IRA

A Roth IRA vs. a Traditional IRA... Which one is best?

The answer, of course, depends on which one (maybe both) is the right fit for your individual financial situation.

Whether you choose a Roth IRA or a Traditional IRA, you need to ask yourself, "Does the plan feature..."

• Tax Deductible Contributions?
• Tax Deferred Investment Gains?
• A Maximum Income Limit for Contributions?
• Taxation of Withdrawals?
• Early Withdrawal Penalties?
• Required Withdrawals?

You should take each of these factors into account when comparing a Roth IRA vs. a Traditional IRA.

To determine which one is best for you, let's examine each one individually.

Tax Deductible Contributions

When pitting the Roth versus the Traditional IRA in the area of tax deductibility, the Traditional IRA wins hands down.

After all, a Traditional IRA is tax deductible, while a Roth IRA is not.

So what does this mean?

It means you fund your Traditional IRA with pre-tax dollars taken out of your paycheck BEFORE you pay income taxes. This has two advantages.

First, if you're unable to contribute the maximum, you may be able to contribute more pre-tax dollars than you're capable of contributing in after-tax dollars. So it can help you to fund your retirement better.

And second, you only pay income tax on the income you have leftover AFTER making your Traditional IRA contribution. This effectively lowers your income in the eyes of the IRS, and it may push you into a lower tax bracket. Regardless, it will lower the amount of income taxes you pay as measured in actual dollars.

So you benefit with an immediate tax savings by investing in a Traditional IRA vs. a Roth IRA.

So a Traditional IRA is better. Right?

No so fast...

The Roth IRA still has some great benefits of its own.

For example, once you make a Roth IRA contribution with after-tax dollars, you never have to pay taxes again.

That's right. Never.

A Traditional IRA is taxed like ordinary income when you withdraw funds during retirement. So that initial tax savings is offset by paying taxes later... Quite possibly much higher taxes.

Any other Roth advantages?

You bet.

Under IRS rules, you're limited as to how much you can contribute to an IRA in any given tax year. Currently, it's $5,000 per year if you're under 50 and $6,000 per year if you're over 50.

Because of the tax treatment during retirement, a maximum contribution to your Traditional IRA isn't equal to a maximum contribution to your Roth IRA.

For instance, let's say you're 30 years old. You contribute the maximum of $5,000 to your Roth IRA...

Meanwhile, your friend, who's also 30 years old, makes the maximum $5,000 contribution as well. But hers is made to a Traditional IRA.

While you're paying a little more upfront since your contribution isn't tax deductible, she's paying a lot more on the back end.

Assume you both get a 10% annual rate of return on your $5,000 contribution. At age 60, you both end up with $87,247.01.

However, you don't end up with the same amount.

Her Traditional IRA is subject to income taxes upon withdrawal, while your Roth IRA is not.

So assuming she pays at least a 25% income tax rate, she'll have $21,811.75 less in retirement.

All because she maxed out a Traditional IRA versus a Roth IRA.

So make sure you think this one through before deciding on a Traditional IRA over a Roth IRA.

Tax Deferred Investment Gains

A Traditional IRA and a Roth IRA both feature tax-deferred investment gains. So neither one has an advantage over the other in this respect...

So what is a tax deferred investment gain?

It simply means that once you contribute funds to your account they grow tax-free.

Interest income... tax-free.

Dividends paid... tax-free.

Sell a stock for double what you paid... tax-free.

So basically, both a Roth IRA and a Traditional IRA allow you to make the best investment decisions possible without having to worry about the tax consequences. This is a great benefit.

However, note when comparing your Roth IRA vs. your Traditional IRA that the "tax-deferred" investment gains are really only applicable to your Traditional IRA.

Why?

Because if you make qualified withdrawals, you'll never have to pay taxes on your Roth IRA investment gains... You never owe a penny.

Your Traditional IRA? While the investment gains are tax-deferred until you decide to withdraw them in retirement, when you do make a withdrawal, they'll be subject to income taxes.

The Maximum Income Limit For Contributions

A Roth IRA vs. a Traditional IRA... Which one is better if you're a high-income earner?

Well, the point here goes to the Traditional IRA.

Why?

Because you can contribute to a Traditional IRA regardless of how much money you earn. Not so with a Roth IRA.

The Roth IRA has established maximum income limits for making a contribution. Generally speaking, if you're married and earn more than $176,000 per year or if you're single and earn more than $120,000 per year, then you're ineligible to contribute to a Roth IRA.

Obviously, if you're unable to contribute to a Roth IRA altogether, then the Traditional IRA wins out in the Roth IRA versus Traditional IRA debate.

Taxation of Withdrawals

As previously mentioned, withdrawals are taxed differently for a Roth IRA and a Traditional IRA.

In fact, qualified withdrawals from a Roth IRA are tax-free.

Not so with a Traditional IRA... It's subject to income taxes. And twenty or thirty years from now, income tax rates might be a lot higher than they are now. We just don't know.

So do I really need to point out which IRA is a better deal when it comes to taxes and withdrawals?

Of course not.

Roth IRA withdrawals are tax-free. So it's a slam dunk Roth win when it comes to a Roth IRA vs. a Traditional IRA.

Early Withdrawal Penalties

A Roth IRA or a Traditional IRA? Which is better when it comes to early withdrawal penalties?

Well, it's a slight win for the Roth IRA.

Funds from both accounts are subject to a 10% early withdrawal penalty if you make an unqualified withdrawal prior to age 59 ½, so you don't gain any advantage in this respect when it comes to choosing the type of IRA you fund.

Both are also subject to income taxes in addition to the 10% penalty.

So how is this a win for the Roth?

Because a Roth IRA allows you to withdraw your original contributions tax-free and penalty-free.

Why?

Because you already paid taxes on your contributions. Remember, you funded your Roth IRA with after-tax dollars.

You didn't do that with your Traditional IRA. You funded that with pre-tax dollars, so withdrawing them early triggers an early withdrawal penalty and income taxes.

See why the Roth has a slight advantage in this respect?

Either way, regardless of which plan you ultimately choose, try to live by this rule...

Don't make unqualified withdrawals from an IRA!

Why?

Not only do you jeopardize your retirement income, but the taxes and penalties are just too steep.

Required Withdrawals

A Roth IRA versus a Traditional IRA when it comes to required withdrawals?

Well, the Roth IRA wins this match hands down.

How's that?

Well, under IRS rules if you have a Traditional IRA, you MUST start taking annual distributions at the age of 70 ½. You're required by law.

Did you catch that?

With a Traditional IRA, you don't have a choice... You have zero flexibility.

You have to take distributions after the age of 70 ½ whether or not you need the funds and regardless of the status of your investment performance for that year.

For instance, let's say you don't need the money and your IRA account takes a 5% annual loss when you reach age 70 ½. You must take a distribution rather than letting your funds continue to grow tax free.

But a Roth IRA?

No such limitation.

In fact, with a Roth IRA, you can keep making contributions long past age 70 ½ if you wish (assuming you have qualified earned income).

Doesn't that sound like a better option?

Conclusion

Which is better... a Roth IRA or a Traditional IRA?

That's the eternal debate among financial planners and tax professionals, and it's a debate that will continue for some time to come.

Why?

Because there's no absolute answer.

The best choice for you might not be the best choice for your neighbor. So you really need to compare the plans and examine all of your choices.

Use our Roth IRA vs. Traditional IRA calculator, and study each of the factors above.

Which plan best fits your financial game plan?

If one stands out over the other, go with that plan.

You may find that both a Roth IRA and a Traditional IRA fit into your financial plans.

For instance, you might prefer a Roth IRA now, but open a Traditional IRA ten years from now when you earn too much money to qualify for a Roth IRA.

Whatever you choose to do, make certain you education yourself on the options available. Once you're up to speed on the rules and the benefits, pick the IRA investment plan that's best for you!