Individual Retirement Accounts – Traditional IRAs, Roth IRAs, and their Differences

Individual retirement accounts (IRAs) are tax-leveraged savings tools that allow taxpayers to financially prepare for their post-work years. While some IRAs may be offered through an employer, taxpayers typically choose and manage their own IRA.

And one of the most important considerations when choosing an IRA is whether it’s considered a traditional or Roth IRA fund. Traditional and Roth IRAs are similar in purpose and practice, but there are a few notable differences. For future retirees, those differences are worth paying attention to because there are major tax ramifications at stake.

The Primary Difference Between Traditional and Roth IRAs – How They’re Taxed

The most important distinction between traditional and Roth IRAs is how contributions or distributions are taxed. Here’s a quick rundown in both cases:

• Traditional IRAs – With a traditional IRA, taxpayers can deduct contributions from their taxes for the relevant tax year. Instead of paying taxes up front, they’re taken out of the distributions (account earnings) when they’re withdrawn later. In most cases, this means once the taxpayer has reached retirement.

In short, traditional IRAs offer a present-day tax advantage and require tax payments later.

• Roth IRAs – Roth IRAs are the opposite. When making contributions to a Roth IRA, taxes must be paid on those contributions. There is no instant tax advantage, so contributions are added to a taxpayer’s adjusted gross income. However, when contributions or qualified distributions are withdrawn, they are tax-free.

In short, Roth IRAs offer a future tax advantage, but contributions are not deductible from the present tax year.

There are a couple of other significant distinctions. One, there is an income upper limit for Roth IRAs, so high earners may not be permitted to make contributions to a Roth IRA or may only be able to make limited contributions. Two, taxpayers have additional flexibility when withdrawing from a Roth IRA. That’s because contributions may be withdrawn tax-free and penalty-free. Contributions to a traditional IRA, by contrast, cannot be withdrawn without paying taxes or penalties, unless certain qualifying criteria are met.

Who Can Contribute to a Roth IRA, and When Can They Make Contributions?

There is no contribution limit for traditional IRAs. Taxpayers may invest as much of their earnings as they wish into such a fund. Taxpayers may also contribute to a Roth IRA whenever they want (prior to the tax deadline of the relevant tax year), but there are limitations on how much may be contributed to a Roth IRA. Here’s what those limits look like:

• The hard limit for every taxpayer, regardless of income, is $6,000 for people under 50 years old and $7,000 for people over 50. This limit applies to all taxpayers whose modified adjusted gross income (MAGI) is below $129,000 (single filers) or $204,000 (married, filing jointly).
• Between $129,000 and $144,000 (single filers) or between $204,000 and $214,000 (married, filing jointly), contribution limits start phasing in. The math is a little cumbersome here, but the formula looks like this:

– Subtract the lower limit of the phaseout range ($129,000 or $204,000) from MAGI
– Divide the answer by $10,000 (married, filing joint or separate) or $15,000 (single filers)
– Multiply that answer by the maximum contribution amount ($6,000 or $7,000)
– Subtract that result from the maximum contribution amount

• Above $144,000 (single filers) or $204,000 (married, filing jointly), taxpayers may not contribute to a Roth IRA.

An important note – contributions to a traditional IRA count toward the total contribution limit for Roth IRAs. For example, if a taxpayer’s contribution limit for their Roth IRA is $6,000 and they decide to invest $1,000 into a traditional IRA first, they may only contribute $5,000 to a Roth IRA for the remainder of the tax year.

What’s the Difference Between a Qualified and Nonqualified Distribution?

Account holders may withdraw contributions from a Roth IRA at any time, for any reason without paying taxes or a penalty. The story is different when withdrawing distributions from a Roth IRA, though. This may be a taxable event, depending on whether those distributions are qualified or not. Here’s the difference:

• Qualified distributions – Two criteria must be met for a distribution to be considered qualified. One, the distribution must be withdrawn at least five years after the taxpayer’s initial contribution to their Roth IRA. There’s a five-year waiting period, in other words.

Two, the distribution must be withdrawn when one of the following are true:

– The taxpayer is 59 ½ years of age or older
– The taxpayer is disabled
– The distribution will be used for first-time home buying
– The distribution is paid to a beneficiary following the taxpayer’s death

Qualified distributions are not subjected to taxes or penalties.

• Nonqualified distributions – Nonqualified distributions may be partly taxable, as Roth IRA withdrawals are first taken from contributions and conversion contributions (distributions from IRAs that are reinvested in the Roth IRA within 60 days of withdrawal). Any distributions withdrawn past the contribution and conversion contribution limit are subjected to income tax and an additional 10 percent penalty.

With traditional IRAs, distributions are subjected to tax upon withdrawal, and an additional 10 percent penalty is also applied if they’re taken out before the taxpayer turns 59 ½.

Traditional or Roth IRA? Which Is the Right Fit for a Taxpayer?

In the end, choosing between a traditional and Roth IRA comes down to this – is your tax rate more likely to be higher in the present, or following retirement? If your present tax rate is higher than your expected retirement tax rate, a traditional IRA makes sense. If you’re expecting higher taxes in retirement, a Roth IRA provides a larger overall tax benefit.

There’s a couple more considerations:

• Traditional IRAs force account holders to take required minimum distributions (RMDs) once they hit a certain age. In 2023, this age threshold is 73. Roth IRAs do not force RMDs, unless the Roth IRA is inherited by a beneficiary. This makes Roth IRAs viable wealth transfer vehicles.
• Roth IRAs do not provide their tax benefits until withdrawal. For taxpayers who have trouble staying disciplined with their savings, this can be an effective way to maximize tax breaks.

Funding a traditional IRA and a Roth IRA simultaneously – along with other retirement accounts like 401(k)s – can diversify tax benefits going into retirement, allowing retirees to plan their future taxes with additional flexibility.

A Tax Professional Can Help Resolve Any Confusion with IRA Options

Retirement is becoming increasingly difficult for taxpayers to fund, but IRAs remain an effective means of preparing financially. There are numerous IRAs available to choose from, though, offered by numerous banks and financial institutions. Choosing the right one can be a challenge, but an important one to get right, given the tax implications involved.

A trusted tax planning expert can provide clarity in this area and match their clients’ tax situation with the ideal IRA fund.