Traditional IRA vs. Roth IRA: Which One Should You Go For?

13 Jul 2020

Have you always preferred being calculative and being on the safe side with your finances? If so, we are pretty sure that you may already have invested or are thinking of investing in your post-retirement life.

How about having an individual retirement account when you reach your retirement eventually?

IRAs or Individual Retirement Accounts are widely considered as effective retirement tools and a great way of saving for retirement. Traditional IRA and Roth IRA are two of the most fundamental and popular post-retirement investment tools available in the American financial markets these days.

Which one would you go for then? The type of IRA you choose has a direct impact on your long-term savings plan and may have an indomitable say on your financial situation when you reach your retirement.

Have you checked your IRA eligibility?

Before making the ‘Traditional IRA Vs Roth IRA' decision, you should first check your IRA eligibility and this will help you make an informed decision. For the current tax year, the maximum amount an individual is allowed to contribute in a year to a Traditional or Roth IRA is fixed at $6000 ($ 7000, if you are aged 50 years or more). This limit has been increased from $5,500 in 2018 (it was $6,500 for the elders in 2018).  But, it is your income that will determine-

  • Whether you are eligible for contributing to a Roth (fully or partially)
  • How much of your Traditional IRA contribution is actually allowed to be deducted from your taxable income this year

As suggested by the current income limits, deductibility from the Traditional IRA accounts is restricted only in the case when you have got enrolled to a savings plan provided by your employer (such as a 401(k)).

Please note that you can make your contributions to a Roth and Traditional IRA in the same tax year till the time the total amount contributed (combining both the IRAs) does not overshoot the stipulated contribution limit. 

Now that you are clear about your eligibility doubts, go through the subsequent sections of this blog to get a fair idea about what separates these IRAs and which one you should opt for.

What are the things that separate these IRAs?

Both these retirement accounts differ on certain parameters, taxation being the most important one. So let us learn the aspects on which a Roth IRA differs from a Traditional IRA so that you can make an informed decision.

1. Age and Income Eligibility

Anyone under the age of 70 and a half and earning an income can contribute towards a traditional IRA. On the other hand, Roth IRAs do not have age restrictions but can have income eligibility criteria. Single taxpayers with modified adjusted gross income (MAGI) less than $137,000 can contribute to the Roth IRA in the year 2019. Couples filing tax jointly having modified AGIs of less than $203,000 can contribute to the Roth IRA. Contribution limits are phased out starting at $122,000 and $193,000 for singles and married couples respectively. The following tables, with a comparison of both Traditional and Roth IRA MAGI phase-out ranges (Traditional and Roth IRA contribution limits) for 2018 and 2019 will make it clearer for you-

 Traditional IRA Deductibility MAGI Phase-Out Ranges

Traditional IRA Deduction Phase-Out table.jpg

Roth IRA Contribution MAGI Phase-Out Ranges

 

2. Tax Break and Tax deductibility

Both the Traditional IRA and Roth IRA offer formidable tax incentives; the difference is with respect to the time when you can avail these tax breaks. While the traditional IRAs are tax-deductible in the year you make the contribution, Roth IRAs give you tax exemption at the time of withdrawal. The withdrawal in case of the traditional IRA would be taxed at ordinary rates. Since both of these are major tax-saving instruments, you would have to plan on the basis of when you would like to avail of such tax rebates.

Another significant difference between a Traditional IRA and Roth IRA is found in their tax deductibility of contributions. Tax-deductible contributions are allowed by traditional IRA whereas Roth IRA accounts are exempted from tax as contributions are done with the after-taxed money. Pretty much everyone can avail the Traditional IRA. However, the tax benefits depend on your income level and on the tax bracket you belong to. Here, your money will have a ‘tax-free' growth, until the time it is withdrawn. Whereas, with the Roth IRA,  this is possible only for employees belonging to certain income levels.

For the Roth IRA, the total amount accumulated after the tax is simply the total value of the account. Whereas, in case of the Traditional IRA, the same is the total of 2 parts-first, the value of your account after you have paid income taxes on all your earnings and also on the tax-deductible contributions and second, the additional earnings from your re-invested tax savings.

3. Rules of Withdrawal

In case of the traditional IRA, you are required to start the RMDs (Required Minimum Distributions) as soon as you are 70½, irrespective of whether you need the fund or not at that point of time. These withdrawals are taxable portions taken as a certain percentage of your total funds. However, in the case of Roth IRAs, you are not mandatorily required to accept these withdrawals. You can let it grow throughout your lifetime and then can pass it on to your heirs. The heirs also have the option of stretching out the distribution over several years without having to pay any taxes on them.

An important point to note here is that Roth IRAs have a five-year aging requirement to be met in order to take penalty-free and tax-free distributions after you have reached the age of 59½. If you are under 59½, with traditional IRAs, you can withdraw up to $10,000 from your account to cover the qualified first-time home-buyer expenses without having to pay the normal 10% early-withdrawal penalty and without any aging requirement.

Apart from these, there are some other points to consider. For example, traditional IRAs give you tax incentives in the contribution year which lowers your adjusted gross income and opens a window for other tax incentives.

Traditional IRA and Roth IRA Comparison

 

Traditional IRA

Roth IRA

Income Limit*

There is no income limit. Anyone with earned income can contribute.

For Single Tax Filers- $137,000

Married Couple Tax-Filers- $203,000

Contribution Limit*

$6,000 ($7,000, if aged 50 or older)

$6,000 ($7,000, if aged 50 or older)

Tax Benefit

Tax deduction at the time of contribution. Normal income tax rates apply on withdrawals.

No tax deduction at the time of contribution. Earnings and withdrawals on retirement are tax-free.

Withdrawal

The distribution must begin after you reach the age of 70½. Heirs will have to pay taxes on distributions.

No withdrawals required during the lifetime. Early withdrawals can be made penalty-free and tax-free if you have completed 5 years from the initial contribution.

*Limits have been taken for the year 2019.

Important things to consider while making your choice between both these IRAs-

Before making that all-important choice between Roth IRA and Traditional IRA, it’s imperative that you learn about their basics first. To start with, you can have a look at both these IRAs from the angle of taxation. With the traditional one, you do not need to incur taxes on the earnings of your investment until the time you begin receiving distributions during your retirement. This allows you to ensure the growth of your money without actually worrying about taxes until you withdraw money. However, you would have to think about how your income would change by the time you reach retirement and what would be the income tax rate at that time. If the tax rate would be higher than what it is now and you anticipate that you would move up the income ladder, it would be better for you to go for the Roth IRA if you don’t want your retired self to pay any taxes. Although, we understand that it is quite difficult to predict future changes in tax-rates, going by their volatile nature.

Another thing to consider here is that, in the Roth IRA, you pay your tax before the investment, rather than paying it when you withdraw the money. The definite advantage here is that you are saved from paying a certain chunk of money during your retirement phase when you are without a monthly income. The ever-increasing tax rates also vindicate the fact that it’s always better to opt for the text payment early into your working life. At the end of your working life, obviously you will be categorized in a higher tax bracket and the taxable amount will take a heavier toll on you.

Enough of tax for now! Let’s turn our attention to a couple more points from different backdrops.

With the Roth IRA, you have to face a restriction on how much contribution you can make in a given year. Even if your income has increased, you just cannot make a hefty contribution as per your wish. Therefore, if you think you will still have enough money to cover for the taxable amount at the time of your retirement, we would suggest you go for the Traditional IRA plan.

Another important feature of the Roth IRA funds is that they provide you with more flexibility with the investment opportunities available. With the Roth IRA, you get a plethora of opportunities such that real estate, mutual funds, stock markets and so on. If you have an eye on these investment portfolios, you better opt for the Roth IRA funds.

Once you have decided on the best suitable IRA for you, the next thing to ponder over is whether you are eligible for your chosen kind of IRA. Firstly, do bear in mind that you won’t be allowed to withdraw any amount from your traditional IRA account till you reach your retirement if your income is beyond a certain level. Also, if your income is beyond a certain limit and you are also the head of your family, you won't be allowed to have a Roth IRA, which is only meant for people who need to withdraw money periodically from their accounts.

On the other hand, you will not be deemed eligible to invest in the Roth IRA funds if your income is too low. Hence, the Roth IRA is more suitable for a particular income group that does not earn too high or too low.

If you have made up your mind to invest in retirement benefits, you will find out that there are plenty of options available and you may have a tough time deciding between Roth IRA and Traditional IRAs. Again, deciding on to choose the perfect retirement plan for yourself will be highly influenced by your investment plans and personal financial situation at that particular point of time. A decision was taken, while keeping an eye on both the present and future tax laws, market mechanisms and trends will help to a great deal for sure.

Our verdict:

We have discussed a lot of things to highlight the comparative benefits of both the IRAs and their eligibility features. But when it actually comes down to how you can use the money lying in your contribution account, the Roth IRA scores higher over its traditional counterpart; simply because of its higher flexibility. This is due to the following reasons-

  1. A Roth IRA is more flexible with its withdrawal rules- Although early withdrawals are not encouraged (from any retirement account, for that matter), a Roth IRA allows an individual to withdraw his contributions (not the earnings, though) any time he wants. He does not need to pay any penalty for the early withdrawal or income tax either.

    The Traditional IRA is not so generous. If you need to withdraw from your Traditional IRA account, you will be levied a 10 % penalty and also you need to pay the income tax on the money you withdraw, as per applicable rates.

 

  1. It is easier to leave money for your legal heirs with a Roth IRA-A Roth IRA provides easier options for passing money to your legal heirs. In contrast to a Traditional IRA, a Roth IRA allows additional contributions even if you are past 70 1/2 years of age, as long as you continue to qualify. Here lies a wonderful opportunity for you to continue saving and thus, let your money grow, with the tax protection provided by your Roth account. This makes Roth IRA a better parking area of your hard-earned money if you wish to leave enough money for your loved ones.

 

  1. A Roth IRA has fewer restrictions for retired individuals- A traditional IRA is somewhat less friendly to the retired individuals as it requires them to go for RMDs or Required Minimum Distributions when they reach the age of 70 1/2 years.  The Roth IRA has got friendlier terms in this sense. It does not have any Required Minimum Distribution (RMD) norms unless the retired individual is inheriting his Roth IRA.  He can keep his savings intact in his account very well and let it grow tax-free till the time he is alive.

 

  1. A Roth IRA gives you a better chance of getting more after-tax money- Both the Traditional and Roth IRAs provides you with a tax break but there is a definite advantage with the Roth IRA, because of the way it treats taxes. As you can not avail tax breaks till the time you reach retirement in case of a Roth IRA (through tax-free withdrawals) you will not be tempted to consume it before then.  A Traditional IRA delivers tax benefit to you when you file taxes annually. This allows you to spend the money away on unnecessary things and thus, hampers you in the long run, if you are not a disciplined saver. If you are not disciplined enough to invest your annual tax savings back into your IRAs, you would be better off opting for a Roth IRA.

 

  1. A combination of 401(K) and Roth IRA gives better tax diversification- If you can fund a Roth IRA in conjunction with a 401 (K), you can achieve a better tax diversification.  A usual 401 (K) provided by most employers includes similar tax benefits as provided by a Traditional IRA. You can divert some of the retirement savings provided by your employer into a Roth account and this would provide you with diverse options to manage your tax burden better in retirement.

Conclusion:

If you are not able to decide as yet, taking the help of a financial consultant is advisable. The experienced financial advisors at Afinoz will guide you in deciding on various investing tools that will help you to ensure better security and diversification of your funds for the future. Also, at Afinoz, our dedicated experts will provide you with the best possible comparative insights so that you can decide between the Traditional IRA and Roth IRAs, keeping in mind your exact financial needs.

For any query, feel free to call us at +91-120-4110376 or visit-https://www.afinoz.com.