Friday Finance: Roth IRA vs. Traditional IRA?
What are Individual Retirement Accounts (IRAs)? They are federally sponsored retirement savings plans. The IRA compares with the 401(k) retirement plans that are offered by companies in the US. Figuring out what is the right plan for you can get complicated. That said, to keep this Friday Finance entry simple and straight forward, we will approach the savings plans for your future retirement, with specific withdrawal limits for the traditional IRA plans versus the flexibility of a Roth IRA.
The contribution limits to all forms of retirement savings for 2027 are listed below. This post will focus on Individual Retirement Accounts (IRAs) listed as the 8th item (Traditional IRA Contribution) in the following table, down to the 13th line item (SIMPLE IRA Contribution) below.
The basics are that with a Roth or Traditional Plan, you are not investing via your company. (Those company plans are listed as the 401(k)/403(b) lines in the table above.
With an IRA you are investing the money yourself. For beginners, start early, and test the waters. With an IRA, the individual calls the shots. These are your retirement assets; therefore, it makes sense to invest through a reliable company like Fidelity, Schwab, Vanguard, or Robinhood to hold your IRA investments. A separate company like these can make the process of automatic payment, annual savings and investing easier. Accessing programs through financial and fiduciary stalwarts will save you time and fees and interest, while you start investing. You can invest all or some of the IRAs in the ETF’s, funds or individual stocks/bonds you want and watch the overall value grow over time.
But First Who is Roth? And Why Should I Care?
Senator William V. Roth, Jr. was a US Senator from Delaware. He co-authored the legislation that created the eponymous Roth IRA. A lifelong Republican, Roth served in the Senate for three decades (1971 – 2001). And YES, you should care about a Roth IRA, especially if you are a Form 1099 wage-earner in a lower tax bracket now than you expect to be when you hit retirement. The key difference between a Roth IRA and a Traditional IRA lies in WHEN you pay taxes on your contributions and the FLEXIBILITY of pre-retirement withdrawals with the Roth vs a Tradtional IRA.
The choice depends on whether you’d rather pay taxes now (Roth) for tax-free withdrawals later, or pay taxes later (Traditional) for a tax break now. A Roth IRA is funded with after-tax dollars, offering tax-free withdrawals in retirement, while a Traditional IRA is funded with pre-tax dollars, providing an upfront tax deduction but taxing withdrawals in retirement. (There are also Roth Conversions, which shift assets from Traditional IRA’s to Roth’s, but that is better understood and navigated on a case-by-case basis).
Here’s a breakdown of the key differences between these savings plans:
Roth IRA
- Contributions: Made with after-tax dollars, are not deductible in the current year. You or your spouse must be earning an income to put money into a Roth. There are specific rules for a “spousal Roth” which you may want to investigate with your spouse, if only one person in the couple is employed.
- Growth: Your money grows tax-free for as long as you want it to exist.
- Withdrawals: Qualified withdrawals in retirement are completely tax-free, provided 1) the account has been open for at least five years and 2) you are at least 59½.
- Required Minimum Distributions (RMDs): There are no RMDs that must be made during the original owner’s lifetime. Taxes are paid before the investment compounds and are not due to any additional tax consequences.
- Best For: People who expect to be in a higher tax bracket in their retirement years than they are currently paying.
Traditional IRA
- Contributions: Made with pre-tax dollars, potentially making them tax-deductible in the current year.
- Growth: Your money grows tax-deferred for as long as it exists. (Note: a Traditional IRA is tax-deferred, while a Roth is tax-free.)
- Withdrawals: Funds are taxed as ordinary income (not as capital gains) when withdrawn in retirement. There are tax penalties on early withdrawal of Traditional IRAs, so be sure to read and learn the rules.
- RMDs: Required distributions generally begin at age 73 and follow a set pattern of distributions and taxes on those assets. Again, you are taxed with the RMDs as ordinary income, so the distribution is taxed at your marginal prevailing tax rate.
- Best For: Younger people who want a tax break now and expect to be in the same or a lower tax bracket in their retirement years.
Choosing the Right IRA for you
- Current vs. Future Tax Brackets: This is the primary factor. If you expect your income (and tax bracket) to be higher in retirement, a Roth IRA is often better. If you expect your income to be lower in retirement, a Traditional IRA may be more beneficial. This can be tricky, as each administration has the ability to juggle these brackets to serve the American public as they see fit.
- Income Limitations: There are income caps for contributing to a Roth IRA, while Traditional IRAs are more accessible, though deductibility can be limited by income if you have a workplace retirement plan.
- Flexibility: Roth IRAs allow you to withdraw contributions (but not earnings) at any time, for any reason, without taxes or penalties. This feature can be handy, especially if you need a Roth as a college savings plan, downpayment plan, or if your withdrawal lies in the other extraordinary expense category.
