Roth vs. Traditional IRA: Which is Best for You?
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Most of us know how important it is to plan ahead for retirement, but do you know which retirement is best for your future? IRAs are one of the most popular retirement savings accounts, particularly among those whose employers do not offer 401ks. But, there are also two main types of IRAs available to choose from: traditional and Roth IRAs.
In this guide, I’ll walk you through the basics of each type of IRA, weigh the pros and cons, and explain any requirements and limitations of both, so you can decide which IRA is best for your financial goals.
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What is an IRA?
An IRA is an individual retirement account with tax benefits that allows you to contribute to your retirement savings regularly. There are a few different types of IRAs, including traditional, Roth, SEP, and SIMPLE IRAs. Of these IRAS types, the traditional and Roth IRAs are the most popular options.
Traditional IRA
A traditional IRA is similar to a 401k for a few reasons. First, traditional IRAs are tax-deferred, allowing you to contribute pre-tax money and only tax at the time of withdrawal (once you reach retirement). Since this account is not taxed before retirement distributions are taken out, your dividends are able to compound much faster than taxable retirement accounts.
There are also two types of traditional IRAS — tax-deductible and nondeductible accounts. The type of traditional IRA you’re eligible for will vary depending on whether you have access to an employer retirement plan and your income.
Deductible IRAs allow you to deduct any contributions made into your account on your tax returns each year, offering you a break on any taxes paid earlier in the year. A nondeductible IRA does not allow you to deduct contributions.
Roth IRA
A Roth IRA is the other most popular individual retirement savings account option. This type of IRA allows your money to compound and grow tax-free. You contribute to a Roth IRA with after-tax dollars, which prevents you from having to pay taxes later on when you withdraw from your account.
SEP IRA
A SEP (Simplified Employee Pension) IRA is a form of traditional IRA for self-employed individuals. Anyone who earns freelance income or who owns their own business is eligible to open a SEP IRA. SEP IRAs offer higher yearly contribution limits, allowing business owners to contribute 25% of their self-employed employee compensation or $58,000 per year (for 2021), whichever is less.
SIMPLE IRA
A SIMPLE (Savings Incentive Match Plan for Employees) IRA is another form of traditional IRA for those who are self-employed or small businesses. While SEP IRAs do not allow employees to make contributions, SIMPLE IRAs do. With SIMPLE IRAs, employers are required to contribute to each employee's IRA annually (either a match of up to 3% of the employee’s salary or a flat rate of 2% of the employee’s salary). This is required whether or not an employee contributes to the IRA.
With a SIMPLE IRA, employees cannot contribute more than $13,500 per year (2021).
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How to Qualify for a Traditional IRA
In order to open and make traditional IRA contributions, you’ll need to earn a taxable salary and be under the age of 70 ½. The amount you may contribute is based on your income and tax bracket.
To qualify for a deductible traditional IRA account in 2021, you must:
Not have access to a workplace retirement savings account (401k or IRA). If you meet this requirement, you’ll be able to deduct the full amount of your contributions into your IRA on your tax returns, regardless of your income level.
If you do have access to a workplace retirement savings account, your income level will determine if any of your contributions are eligible for tax deductions.
- If you make under $66,000 per year (gross income) and are a single file OR if you make under $105,000 per year (gross income) jointly, you can deduct the entire amount of your IRA contributions from your tax return.
- If you make over $66,000 AGI per year, you’ll be eligible for a partial deduction that will phase out at $76,000. Joint filers making over $105,000 will also receive incremental deductions that will phase out at $125,000.
If you do not fit the above criteria but are under 70½ you can open a nondeductible traditional IRA.
Withdrawal rules
Traditional IRA
Since traditional IRAs are designed to help you save money for retirement, withdrawing early is not only discouraged, it’s also penalized. You are allowed to begin withdrawing from your traditional IRA at age 59 ½ penalty-free. Your IRA withdrawals will then be taxed as income at the federal and state levels.
You can legally withdraw your funds before you reach retirement age, but in addition to paying tax on your distribution, you’ll also pay a 10% early withdrawal penalty fee to the IRS. There are a few situations where the IRS waives this penalty fee, including qualifying higher education purposes, first-time homebuyers down payment (up to $10,000), qualifying medical and COVID-19 expenses, and permissive withdrawals after the death of an IRA owner.
Lastly, while you can begin withdrawing funds at 59 ½ years old, you are legally required to begin taking out required minimum distributions each year, once you reach 70 ½ years old. You can calculate your required minimum distribution by dividing your traditional IRA account balance as of the last day of the previous year (for example, December 31st, 2020) by your life expectancy factor. You can find your IRS life expectancy factor here.#### How to Qualify for a Roth IRA
Unlike traditional IRAs, you’ll need to meet income limitations in order to qualify for a Roth account. The 2021 income limitations are:
- $139,000 AGI or less for single filers
- $206,000 AGI or less for joint filers/married couples
In addition to the above income limits, you must also make taxable income to qualify.
Roth IRA
While you’ll be charged a penalty fee in most cases when withdrawing early from a traditional IRA, a Roth IRA has different rules. You’re allowed to withdraw from your contributions at any time, without penalty, no matter your age.
You cannot, however, withdraw investment earnings you’re accumulated within your Roth IRA early. If you do, the IRS will charge you a penalty fee.
For instance, if you have $70,000 in your Roth IRA and $40,000 of that money is contributions and $30,000 is investment earnings, you can only withdraw up to $40,000 without paying an IRA penalty.
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Contributions and limits
Both traditional and Roth IRAs have yearly contribution limits set by the IRS. For the 2021 tax year, the contribution limits are:
- Under 50 years of age - $6,000 per year
- Over 50 years of age - $7,000 per year
This limit applies to all traditional and Roth IRA accounts you contribute to. For instance, if you have an employer-sponsored Traditional IRA and a Roth IRA and you’re 35 years old, you can only contribute a total of $6,000 across both accounts for 2021.
Pros and cons
Traditional IRAs
Pros
- Reduce taxable income. If you’re eligible for a deductible traditional IRA, any contributions made in that year will be deducted from your taxable income. This will decrease the amount of income tax you’ll pay that year.
- Wide eligibility requirements. One of the main perks of traditional IRAs is that they’re available to anyone earning taxable income under the age of 70½. There are no income restrictions to open a traditional IRA, though there are restrictions regarding whether contributions are deductible.
Cons
- Contribution limits. Once you turn 70½, you’re no longer allowed to continue contributing to your traditional IRA.
- Minimum distribution requirements. Once you turn 70½, you’re required to begin taking out required minimum distributions each year.
Roth IRAs
Pros
- Tax-free retirement withdrawals. Since you contribute to a Roth IRA post-tax, you’ll be able to take out distributions without paying tax on them in retirement.
- Access to contributions before retirement. Although it’s advantageous to leave your Roth IRA alone until retirement, if you do need to withdraw funds sooner, you have full access to your contributions without incurring a penalty from the IRS.
- No age limit on contributions. If you have a Roth IRA, you can continue making contributions after the age of 70 ½, unlike with a traditional IRA.
Cons
- No yearly tax deductions. Since you won’t be subject to an income tax on your distributions in retirement, you’re not able to deduct contributions on your taxes.
- Not available for higher income tax brackets. If you make above the Roth IRA income limits, you won’t be eligible to open or contribute to this type of retirement account.
Which is better: Traditional or Roth IRA?
Both traditional and Roth IRAs have their own pros and cons to consider. Both offer tax advantages, but a traditional IRA allows you to deduct your contributions now, and pay taxes on your money later. However, a Roth IRA allows you to make withdrawals without worrying about taxes since contributions are made post-tax.
In some cases (and if you qualify) it might make sense to open both a traditional and Roth IRA. I would recommend making sure you max out any employer benefits offered before opening or contributing to an additional account, to ensure maximum employer matching.
If you meet the income limits and want the ability to access your contributions at any time, a Roth IRA may be best. However, if your employer offers a traditional IRA or if you do not qualify for a Roth IRA, stick with a traditional IRA.
FAQs
Does it make sense to have both a traditional and Roth IRA?
In some cases, yes, having both types of IRAs can be a good tax diversification strategy. This allows you access to taxable income distributions through a traditional IRA and non-taxed income through your Roth IRA. This can be a smart move if you’re not sure what tax rate you’ll owe when you’re older. However, to make the most of any retirement account, be sure you’re fully taking advantage of any employer match benefits first.
Should I convert a traditional IRA to a Roth IRA?
Some people may decide to convert their traditional IRA to a Roth IRA to avoid required minimum distributions or to obtain access to all contributions at an earlier age. If you are considering converting your traditional IRA to a Roth IRA, be aware that you’ll be required to pay taxes on this conversion, though you might be able to spread out the conversion over two years, lowering your tax percentage. You can also consider an indirect rollover if you’re hoping to avoid paying taxes. You’ll need to ensure your distribution is placed into your Roth IRA within 60 days or receiving it to avoid tax penalties. When are you required to stop contributing to a Roth IRA? Unlike traditional IRAs, Roth IRAs do not require you to stop contributing at any age. You can continue making contributions after 70½.
What is the 5-year rule for Roth IRAs?
Although you can withdraw your contributions at any time, tax-free with a Roth IRA, if you hope to withdraw any earnings without incurring taxes, you should apply the 5-year rule. This rule states that you must wait until five years after your first contribution to withdraw any earnings tax-free. You can still withdraw earnings earlier, but you’ll be subject to income tax.
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The bottom line
Both traditional and Roth IRAs offer flexible ways for individuals to contribute to their retirement savings. Ultimately, I recommend taking advantage of any employer match retirement accounts first (particularly if you have a 401k, which has higher yearly contribution limits), before opening a different IRA. If you have a 401k, opening a Roth IRA might make more sense, since you’ll be able to enjoy both taxed and untaxed distributions in retirement.
If you don’t qualify for a Roth IRA, a traditional IRA is still a great option to help you save for retirement. If you’re self-employed or own your own business, look into SEP and SIMPLE IRAs, both of which offer higher yearly contribution limits than traditional and Roth IRAs.
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Writer
Courtney Johnston is a freelance writer, specializing in finance, travel, and health. She has written for The Chicago Tribune, Benzinga, BestReviews, Mashvisor, Fundera, MoneyGeek, and The Culture Trip. She also teaches writing instruction at the University of Indianapolis. Courtney currently resides in Indianapolis.
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