Roth IRAs vs. Traditional IRAs

Roth IRAs vs Traditional IRAs
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When it comes to Roth IRAs vs traditional IRAs, there is some confusion about which option is best. 

An IRA is an individual retirement account. Unlike employer-sponsored 401(k)s, IRAs allow individuals to make their own contributions. 

According to the Investment Company Institute, “Americans held $11.0 trillion in individual retirement accounts (IRAs) at year-end 2019, accounting for 34 percent of the $32.3 trillion in dedicated retirement assets. Forty-four percent of IRA assets, or $4.8 trillion, were invested in mutual funds. The most common type of IRA is the traditional IRA.”

However, even though the traditional IRA is the most common, it doesn’t mean Roth IRAs are unpopular.

The Investment Company Institute reports, “About one-third of IRA investors have Roth IRAs. […] Thirty-five percent of Roth IRA–owning households in 2017 indicated their Roth IRA was the first type of IRA they opened.”

Both are non-employer-sponsored retirement savings accounts, but the key difference comes down to taxes.

The short and simple Roth IRA vs. traditional breakdown works like this according to the Tax Policy Center: “Qualified contributions to traditional IRAs are excluded from tax and grow tax-free, but withdrawals are taxed. Contributions to Roth IRAs, conversely, are taxed in the year they are made. But account assets grow tax-free, and withdrawals after age 59½ are not taxed.”

It’s important to know that the choice is a personal one. Either one of these is right for someone looking to save for retirement.

Ultimately, it comes down to whether you want to take advantage of a tax break today (traditional IRA) or enjoy tax-free withdrawals in the future (Roth IRA).

Here’s even more good news: It doesn’t have to be Roth IRA vs. traditional IRA. You can have both!

The Investment Company Institute found, “Households often invest in both traditional and Roth IRAs—71 percent of Roth IRA–owning households in 2017 also owned traditional IRAs.”

Of course, there is more to it than this simple introduction, which we are breaking down in the rest of this article and in this infographic

Roth IRAs vs Traditional IRAs

Traditional IRAs

The traditional IRA was established in 1974 and allows anyone with earned income to contribute. 

When you make contributions, the money goes into the account pre-tax and your contributions grow tax-deferred. 

Essentially, a traditional IRA gives you a tax deduction immediately (subject to income limits). You’re only taxed when you take out the money.  

This is the key difference between Roth IRAs vs. traditional IRAs.

Since an IRA is designed for retirement, you are technically not supposed to take withdrawals until you reach a certain age.

For a traditional IRA, you may make withdrawals without penalty after the age of 59½. However, if you withdraw before age 59½, you are subject to a 10% penalty.

With a traditional IRA, you are also mandated to take distributions (RMDs) once you reach age 72.

No matter when you withdraw, before age 59½ or after, your withdrawal will be taxed as earned income in the year the withdrawal is taken. 

Roth IRAs

The Roth IRA is very similar to a traditional IRA with a few key variances.

The Roth IRA was introduced in 1997 and sponsored by Senator William Roth (hence the name).

The Roth IRA allows those with earned income below a certain level (single individuals earning below $140,000 or married couples earning below $208,000) to contribute.

The key feature that separates the Roth IRA from a traditional IRA is that the Roth allows for after-tax contributions, and these contributions grow tax-free.

Because your contribution is made after taxes are paid, you won’t get a tax break (aka deduction) like you do with the traditional IRA.  

However, you will be able to withdraw the money penalty-free and tax-free if you are older than age 59½ and have held the account for 5 years or more

This is a KEY benefit of the Roth IRA. 

Another difference between the Roth IRA and traditional IRA is that, with the Roth, there are no required minimum distributions (RMDs)

This allows your funds to continue to grow tax-free.

It also means, when the market is high or down, you aren’t forced to sell when you don’t want to – or when it’s not advantageous for you to do so. 

When comparing Roth IRAs to traditional IRAs, another benefit to the Roth is the better terms for early withdrawals. 

If you need the funds for an emergency, to purchase your first home or start a business, the Roth allows you to pull money out with a 10% penalty on the earnings ONLY if you withdraw prior to age 59½. 

Because the Roth is funded with after-tax dollars, if you are under 59½, you only pay a penalty on the earnings. You will also have to pay income tax on the amount withdrawn. 

Here is a breakdown of the Roth IRA withdrawal rules: 

If you take withdrawals from a Roth IRA you’ve had LESS than five years.

If you take a distribution of Roth IRA earnings before you reach age 59½ and before the account is five years old, the earnings may be subject to taxes and penalties. You may be able to avoid penalties (but not taxes) in the following situations:

  • You use the withdrawal (up to a $10,000 lifetime maximum) to pay for a first-time home purchase.
  • You use the withdrawal to pay for qualified education expenses.
  • You use the withdrawal for qualified expenses related to a birth or adoption.
  • You use the withdrawal to pay for unreimbursed medical expenses or health insurance if you’re unemployed.

If you take withdrawals from a Roth IRA you’ve had MORE than five years.

If you’re under 59½ and your Roth IRA has been open five years or more, your earnings will not be subject to taxes if you meet one of the following conditions:

  • You use the withdrawal (up to a $10,000 lifetime maximum) to pay for a first-time home purchase.
  • You use the withdrawal to pay for qualified education expenses.
  • You use the withdrawal for qualified expenses related to a birth or adoption.
  • You use the withdrawal to pay for unreimbursed medical expenses or health insurance if you’re unemployed.

If you are over age 59½ and you want to withdraw for whatever reason, you will not have to pay the 10% penalty or income tax. 

Lastly, unlike traditional IRAs, your heirs will pay no taxes on the proceeds from an inherited Roth IRA. 

Note: It doesn’t have to be Roth IRA vs. traditional IRA. You can have both, but you can only put in a total of $6,000 for both, or $7,000 if you are over age 50.

benefits of Roth IRA
Watch the video below for a deep dive into the Roth IRA.

Contribution Limits and Phaseouts for Roth and Traditional IRAs

The IRS recently announced new 2022 contribution limits for qualified retirement plans.

While 401(k) and other retirement plans will see an increase in limits, IRA and Roth IRA contribution limits for 2022 will stay the same, with a $6,000 maximum contribution limit. 

The catch-up contribution for people age 50 and over remains unchanged, with an additional $1,000 contribution for a total of $7,000.

However, there are changes to IRA Phaseouts.

Deductible IRA Phaseouts for 2022

For singles and heads of household who are covered by a workplace retirement plan, such as a 401(k), and contribute to a traditional IRA, the phaseout range is between $68,000 and $78,000, up from $66,000 and $76,000 in 2021.

For 2022, the adjusted gross income (AGI) phaseout range for married couples filing jointly who are contributing to a traditional IRA is between $109,000 and $129,000 for 2022, up from $105,000 and $125,000 in 2021.

If you contribute to an IRA but are not covered by a workplace retirement plan and are married to someone who is, the deduction is phased out if your joint income is between $204,000 and $214,000 in 2022. This is up from $198,000 and $208,000 in 2021.

[Related Read: 2022 Retirement Plan Contribution Limits]

Roth IRA Phaseouts for 2022

The phaseout range for married couples filing jointly who are covered by a workplace retirement plan and contribute to a Roth IRA in 2022 will increase.

For 2022, it will be between $204,000 and $214,000, up from $198,000 and $208,000 in 2021.

For heads of household or those filing as single, the phaseout range is between $129,000 and $144,000 in 2022, up from $125,000 and $140,000 in 2021.

Remember, you can still contribute to an IRA even if you earn too much — it’s just nondeductible.

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