Traditional IRA vs Roth IRA: Which Should You Choose?

When it comes to choosing how to save for the future, you might find yourself deciding between a Roth IRA and a traditional IRA. These IRAs both give you the opportunity to set money aside for the future and there are tax benefits to be had from each one.

So, how do you know which one is right for you? In this article we take a look at each one to help you decide which one you should be putting your money into.

What is an IRA?

An Individual Retirement Account (IRA) is a method of saving for your retirement in a way designed to save you taxes. It is a personal savings plan which allows you to put money aside for when you are retired in a way that supplements your employer-sponsored savings plan with a wider range of investment choices.

There are different types of IRA available depending on the benefits that you need and what you plan to do with the money, so it is important to think carefully about your current situation and the one you plan to be in when you retire. Once you have worked this out, you are better placed to decide how to invest for the future.

Traditional IRAs

One of the most important points to remember when it comes to traditional IRAs is that the contributions are tax-deductible on both federal and state tax returns for the year in which you make the contribution. Your withdrawals are therefore taxed at your own income tax rate when you make them, which for most people tends to be during retirement.

The contributions that you make to your IRA tend to lower your taxable income in the contribution year, which in turn lowers your adjusted gross income (AGI). In some situations, you might find that this helps you to qualify for other tax incentives.

Traditional IRAs are designed not have money withdrawn from them until you reach the age of 59½. Should you do so, you will be liable for a 10% early withdrawal penalty, and you will have other taxes to pay on the amount. There may be circumstances, such as using up to $10,000 to pay for qualified first-time homebuyer expenses or qualified higher education expenses, where you can avoid the penalty, but the taxes will still apply.

Ideally, a traditional IRA should be taken by someone who assumes that they will be in the same tax bracket or lower when they come to make their withdrawals. The contributions to a traditional IRA can come from either pre- or after-tax dollars, and in 2023 the maximum contributions are $6,500 for the under 50s and $7,500 for the over 50s.

Roth IRAs

A Roth IRA is a special type of individual retirement account where you can contribute your after tax dollars which can grow and be withdrawn without tax after retirement if the account has been open for at least five years. With Roth IRAs, there is no tax deduction when you make a contribution, and you will not lower your AGI for that year.

However, as you have paid your tax bill upfront, the withdrawals you make from your Roth IRA are tax free when they are made during retirement. It is worth keeping in mind that there are income eligibility restrictions attached to Roth IRAs, which mean that currently, a single filer must have a MAGI of less than $153,000, with contributions phasing out starting with a MAG of $138,000. In the case of a married couple, your modified AGIs must be less than $228,000 and contributions phase out starting at $218,000.

There are no required minimum distributions (RMDs) with a Roth IRA, so there is no requirement to withdraw money at any age. As beneficiaries will not owe income tax on any withdrawals they make from your Roth IRA, they have become a popular way to transfer wealth.

In a Roth IRA, it is possible to withdraw sums equivalent to your contributions before the age of 59½ tax free and without the fear of penalties before the due date of your tax return. However, you must have held the IRA for at least five years before you can start to withdraw from it.

These types of IRA tend to be best suited to individuals who expect to be in a higher tax bracket when they decide to start making withdrawals. Currently, your contributions come from your after-tax dollars and in 2023 they are capped at $6,500 for the under 50s and $7,500 for the over 50s.

Main differences

Whilst both types of IRA can offer tax breaks but claiming them comes down to timing. The traditional IRA provides tax benefits now, whilst the Roth IRA allows you to enjoy tax free withdrawals in the future. It is therefore important to try and calculate whether you think your tax bracket will be the same when you retire, or whether it is likely to be higher or lower.

The withdrawals system is also another key difference between traditional IRAs and Roth IRAs, as whilst the traditional system requires you to take mandatory RMDs, there is no requirement to take anything from the Roth IRA if you don’t want to.

There are IRS rules on IRA eligibility which may restrict which IRA you can have. When it comes to deciding which IRA to opt for, you need to decide what its primary use will be. Think about how you plan to contribute to it, when you want to withdraw from it and whether you want to use it to pass some of your wealth on to your children.

Your IRA choices will be based on your own personal circumstances, so it is important to seek independent financial advice or use an online calculator to help you decide which type of IRA you are better suited to. There are some clear differences between the two types of IRA, so some it is important to take a glimpse into the future to see what the purpose of your IRA might be.