When it comes to planning for retirement, there are many products to choose from. Consumers can select investing in mutual funds, the stock market, fixed annuities, and many others. Some of the most popular financial accounts include Individual Retirement Accounts or IRAs. There are two major types of IRA: the Roth IRA and the Traditional IRA. Many people are confused about the differences between these two types and what advantages/drawbacks each of them have.
The Traditional IRA came into being in 1974 with the passage of the Employee Income Security Act. It is a retirement account where the account holder may invest money in anything the account’s custodian (banks, brokerages, etc.) allows. This can be certificates of deposit, stocks and bonds, and mutual funds.
The Roth IRA, originally called “IRA Plus”, was proposed in 1989 and established by the Taxpayer Relief Act of 1997. It is named for Senator William Roth of Delaware, who was one of the two original sponsors of the plan. Just like a Traditional IRA, account holders may choose to invest in mutual funds, stocks, securities, and retirement annuities purchased from life insurance companies. Within just a few years of the establishment of the Roth, IRA owners in the United States had invested over $3 trillion in such plans.
What is the Difference between Roth and Traditional IRAs?
There are several important differences between the two types of retirement accounts. Each type has its own strengths and weaknesses, which will be discussed below.
- Tax Benefits: Dividends earned by Roth IRAs grow tax free, and qualified withdrawals from the plan are also tax free. In a Traditional IRA, the dividend growth is tax-deferred. Contributions to the plan are tax-deductible. Account holders pay taxes on qualified withdrawals of Traditional IRA plans.
- Age Requirements: For Roth IRA holders, they may contribute to the plan at any age. Conversely, Traditional IRAs can be contributed to by account holders only until the age of 70 ½ years.
- Withdrawal Taxes: Earnings after five years of the establishment of a Roth IRA are tax free, and withdrawals are also free of federal income taxes. For Traditional IRA account holders, pre-tax contributions incur taxes when withdrawn. Also, any earnings of the plan require taxes to be paid if they are withdrawn. Earnings are considered income, thus the need to pay taxes on them.
- Income Requirements: For Roth IRAs, the amount of your income determines how much you can contribute annually to the plan. Currently, single tax filers making up to $116,000 qualify for full contributions to the plan, which are $5500 if age 49 and below or $6500 if over 50 or over. Joint tax filers may make up to $183,000 in income to qualify for the full annual contribution. In the case of married couples who file taxes jointly, each may contribute the full $5500 per year if age and income requirements are met. Traditional IRA holders do not have any limits on the amount of annual contributions they can make to the plans; in other words, income has no bearing on contributions.
- Penalties for Early Withdrawal: If you are the owner of a Roth IRA account, you may pay significant penalties and taxes on withdrawals made before age 59 ½ IF you have owned the account for 5 years or more. Penalties can be as high as 10% in additional taxes. Direct contributions to the plans may be withdrawn at any time tax- and penalty-free. There is also a maximum tax-free lifetime withdrawal of earnings of $10,000 if the money is used to purchase a primary residence. Traditional IRA owners don’t have as big of a problem withdrawing funds from the plans; if the account holder is at least 59 ½, he or she can withdraw money from the plan. If younger than the cutoff age, the penalty may be as high as 10%, much like in Roth IRAs.
- Requirements for Minimum Distributions: During the lifetime of a Roth IRA account holder, there are no Minimum Required Distributions (MRDs). In other words, you don’t have to take money from the account if you don’t need to. Conversely, Traditional IRA account holders must start taking MRDs in the year they turn 70 ½ years of age.
What is the Same About Traditional or Roth IRAs?
There are many small similarities between these types of retirement plans, such as the types of investments made and some of the age requirements. The main similarity to be aware of is that contributions can be made up until mid-April for the previous tax year. For 2017, the deadline is April 18th to contribute for the purposes of the 2016 tax year.
How Do I Choose between Roth or Traditional IRAs?
Faced with the differences and similarities between these two types of retirement accounts, how does one choose which is better for their purposes? There are several things to consider when establishing a retirement plan – and financial experts agree that the sooner one begins to fund a plan, the better.
- The tax benefits – if you want a tax break right now, a Traditional IRA may be a better choice. If you want to reduce your taxes after retirement, the Roth IRA is the way to go.
- Contributions – Roth IRA account holders may only contribute a portion of their after-tax earnings, while those with Traditional IRAs don’t have any constraints on contributions. If you’re ready to put away a lot of money, the Traditional plan is the better choice. For younger people who can wait and invest steadily over the course of their careers, Roths make more sense. High wage earners may be stifled by the limits imposed in contributing to Roths, however, and may be better served by a Traditional plan if income limits are exceeded during your career.
- Penalties – Penalties for withdrawing contributions and earnings from IRA accounts may be steep. Again, if you don’t foresee any need to withdraw from your retirement account, a Roth is the better choice. If you may have to withdraw early from your plan, a Traditional IRA comes with fewer penalties.
- Retirement benefits – for those investors who may not wish to be forced to take out earnings or distributions from their retirement plans, such as those who want to leave money for heirs, a Roth is the likely choice. Traditional IRA account holders are required to start taking distributions in the year they turn 70 ½, which may mean less to pass on to children or other heirs.
Whichever path you choose for funding your retirement, it is critical to speak to a financial professional. He or she can help you make the best choice for your circumstances in life, giving you the ability to live a comfortable and secure retirement.