Roth IRA vs Traditional IRA: The Cold Hard Facts

Investing
Updated: 6th Jan 2021
Written by Drew Cheneler
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Investing
January 6, 2021
Written by Drew Cheneler

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Looking to set up an individual retirement account and start actively saving for retirement? That’s a great idea! But one of the big things you’ll need to decide is whether to choose a Roth IRA vs a traditional IRA.

While both of these accounts can help you save for the future, it’s important to know what their benefits and differences are so you can make the right choice for your needs.

Let’s break down both of these IRA types in more detail.

Roth IRA vs Traditional IRA Overview

Both Roth and traditional IRAs are examples of individual retirement accounts. These are special types of retirement accounts that you can open if you don’t have a 401(k) or a similar shared retirement account with your employer or a larger organization.

Traditional IRAs have been around for longer and first started in 1974. Roth IRAs only began in 1997.

Both types of IRAs are used to save for the long-term, so you have some money after retirement.

While both Roth IRAs and traditional IRAs share a few benefits, such as the ability to grow their investments without taxes, there are also some big differences you should keep in mind when choosing which one to open.

Differences Between Roth IRAs and Traditional IRAs

Let’s break down the differences between Roth IRAs and traditional IRAs in more detail.

#1 Income Restrictions

Both types of IRAs have certain income restrictions and limits.

With a traditional IRA, you can contribute no matter your earned income level. For both Roth and traditional IRAs, you can only contribute $6000 per year if you are younger than 50 years old or $7000 per year if you are older than 50.

However, Roth IRAs have certain income limits. As of 2020, any single individuals must have a modified adjusted gross income (MAGI) of less than $139,000.

Couples can have MAGIs of less than $206,000. Furthermore, any contributions to a Roth IRA account will be phased out starting at $124,000 and $196,000, respectively.

#2. Age Restrictions

Fortunately, neither IRA type has any age restrictions when it comes to contributions.

But keep in mind that both IRA types limit you to $6000 in contributions per year or $7000 per year if you are below age 50 or are aged 50 and older, respectively.

#3. Tax Breaks

Furthermore, both types of IRAs differ significantly in terms of their tax breaks.

A traditional IRA account allows you to add tax-deductible money each time you contribute. When you make a withdrawal from a traditional IRA account, that withdrawal will be taxed at your current income tax rate or bracket.

For many people, this is advantageous since they usually make IRA withdrawals after their income has significantly decreased, meaning they technically count as a lower tax bracket.

Additionally, any contributions to traditional IRAs do not need to be counted during your current tax year. This means any traditional IRA contributions are tax-deductible and may qualify you for a greater tax return during a given year.

In contrast, Roth IRAs don’t require you to pay taxes when you make withdrawals. Instead, you pay taxes on any of the contributions you make as you build up the account toward retirement.

Since, with a Roth IRA, you already paid any taxes on that money, you won’t owe anything when the time finally comes to withdraw your nest egg and live-in comfort.

In this way, both Roth and traditional IRAs offer significant tax breaks. The biggest difference is when those tax breaks kick in.

  • Traditional IRAs have you pay taxes on any contributions or money when you make a withdrawal
  • Roth IRAs have you pay taxes on your contributions, but not when you make a withdrawal

#4. Withdrawals

Both IRA types have some differences in terms of withdrawals before you retire.

With a traditional IRA, you have to pay taxes in addition to a 10% early withdrawal penalty if you take money from your IRA account before the age of 59 ½. There are a couple of exceptions to this penalty:

  • if you use the money to pay for first-time homebuyer expenses and only take up to $10,000
  • if you use the money to pay for certain qualifying higher education costs
  • if you use the money for certain hardships, like medical expenses or disability costs

With Roth IRAs, you can withdraw any sums you want so long as they are equivalent to your Roth IRA contributions (penalty tax-free, too) whenever you like.

#5. Distribution Rules

When it comes to traditional IRAs, you must start making withdrawals (called distributions) of a minimum amount. These are called RMDs or required minimum distributions.

You have to start taking RMDs by age 72 regardless of whether you need the money or not. These are taxable withdrawals of a percentage of your total funds.

In contrast, you never need to take out money from a Roth IRA. As a result, people with lots of wealth to transfer over to the next generation (such as their children) may prefer a Roth IRA due to this extra freedom.

Roth IRA vs Traditional IRA: Our Two Cents

In general, it’s a much better idea to go with Roth IRAs instead of traditional IRAs if you can qualify.

Here’s a breakdown of Roth IRA benefits:

  • You have much better early withdrawal rules. Roth IRAs don’t require you to pay a penalty or extra taxes whenever you withdraw, even if you aren’t retired. Remember, this is partially because you pay taxes on your contributions during the year that you make them. So any money you take out of a Roth IRA is totally tax-free. This can come in handy if you need a little extra cash in an emergency or need to pay for an unexpected expense
  • Furthermore, Roth IRAs don’t have lots of restrictions for their users or retirees. Remember, traditional IRAs force you to start taking small but noticeable distributions by age 72. If you have a Roth IRA, you can keep your savings and have your account grow for as long as you are alive. This makes Roth IRAs great wealth transferring vessels

More Tax Advantages with a Roth IRA

Perhaps most importantly of all, Roth IRAs are better when it comes to taxation, period. Let’s break it down.

With traditional IRAs, you must pay taxes whenever you withdraw from your account. With Roth IRAs, you only pay taxes on the contributions you make during your working tax years.

This means that you might pay less in taxes over the long run with a Roth IRA compared to a traditional IRA.

Let’s break it down in simple math. Say that you had a Roth IRA with a total combined amount of $100,000 (real Roth IRAs usually have more than this – the number is low just to keep the example simple). When you withdraw that money, you do not need to pay any taxes whatsoever.

Instead, you paid taxes at rates of around 18% with each contribution you made to the account throughout your life.

In contrast, say that you have a traditional IRA with the same combined value of $100,000. When you take out that $100,000, you will need to immediately pay taxes.

Since $100,000 is quite a bit of cash, chances are you will need to pay more taxes and only get $70,000-$80,000 in total when all is said and done.

In this way, contributing to a Roth IRA allows you to benefit from more of your money than a traditional IRA.

Roth IRA vs Traditional IRA: Why Do I Need a Retirement Account?

Everyone needs a retirement account at some point. Even when we retire, we still need a way to pay the bills!

While many of us still hope to benefit from Social Security, a retirement account is a much more surefire way to make sure you have enough money to enjoy your golden years (especially since Social Security may actually run out of funding over the next decade or two).

Plus, a Roth or traditional IRA allows you to take charge of your savings rather than leave it up to the government.

Best Places to Open a Traditional IRA or Roth IRA

There are lots of great places to open either traditional or Roth IRAs. Contact the following companies to see if you qualify.

#1. Betterment

Betterment offers an excellent investment platform and provides easy to access retirement accounts for anyone who needs them.

They charge no account minimum, so you can start saving without a single penny in the account. Plus, there’s only a 0.25% fee per year. This robo-advisor is well suited to help you save for retirement.

Learn More: Betterment Review

#2. Vanguard

Vanguard also offers both traditional and Roth IRAs. You get to choose your own investments and each available fund is high-quality (meaning you can rest assured that your investments will grow in value over decades).

Vanguard’s funds come without any sales commissions, sales load, or account service fees, making it an affordable and reliable place to see your IRA options.

Learn More: Vanguard Review

#3. Fidelity

Like Betterment, Fidelity offers IRAs without any account minimums or account fees. Or you can alternatively pay the optional “advisory fee” and have Fidelity take care of your IRA management for you. it’s a great “hands-off” IRA platform option for those without a lot of financial savvy.

Learn More: Fidelity Review

#4. Charles Schwab

We’d also recommend looking into Charles Schwab, which offers both major types of IRAs.

You might specifically want to look into Charles Schwab since it offers 24/7 professional guidance, lots of online tools and resources, and even a special “custodial IRA option.”

This is great if you have a child earning their own income and want to give them a head start with their retirement.

Learn More: Charles Schwab Review

Bottom Line: Roth IRA vs Traditional IRA

Ultimately, both traditional and Roth IRAs are great choices if you want to start saving early and make sure you have a big enough of a nest egg come retirement.

We’d heavily recommend you consider investing in a Roth IRA if you qualify, as you’ll benefit from more tax advantages and a bigger nest egg by the time you retire compared to a traditional IRA.

Drew Cheneler
Drew Cheneler
Drew is a recognized Credit, Small Business, and Personal Finance Expert. He has been quoted in CNBC, Fox Business News Section, The Huffington Post, Business.com, Moneyunder30, US Chamber of Commerce, and more. He is known for breaking down complex personal finance topics into action-oriented advice, so you can make the most of your hard-earned money.