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Should I Get a Traditional or Roth IRA?

Not sure about how to use an IRA or which type to choose? Money Girl cuts through the confusion and explains the pros and cons of IRAs and how to know if a traditional or Roth account is best for you.

By
Laura Adams, MBA
9-minute read
Episode #688
The Quick And Dirty

Knowing whether you should choose a traditional or a Roth IRA largely depends on your future income and tax rate, which no one knows for sure. Therefore, making the best decision depends on whether you prefer saving money on taxes sooner, with a traditional IRA, rather than later, with a Roth IRA.

If you plan to have a financially comfortable retirement, there's no getting around the fact that you should use one or more tax-advantaged retirement accounts. I'm a big fan of the Individual Retirement Account or IRA because it's available to anyone with some amount of earned income, no matter if you're a teen or a retiree.

Unfortunately, I've found that many people have questions about IRAs that keep them from opening one up. For instance, they're unsure how IRAs work or whether they should have a traditional or Roth account.

This post will clear up any confusion you may have about IRAs. Keep reading to find out if a traditional or Roth is best for you, where to open your account, and how to invest IRA contributions wisely. 

What is an Individual Retirement Account (IRA)?

An important concept to understand about an IRA (or any retirement account, for that matter) is that it's not an investment. An IRA is an account where you put your investments. 

I think of a retirement account like your house or apartment. It shelters and protects you, but it isn't you. Similarly, an IRA is just a shelter that protects your investments from taxation while you own them inside the account.

You can put just about any investment in an IRA, such as stocks, bonds, exchange-traded funds (ETFs), mutual funds, index funds, certificates of deposit (CDs), and money market funds. If you open a self-directed IRA, you can even own less mainstream investments, such as real estate or businesses in your account. But we're just going to focus on traditional and Roth IRAs here.

What is a Traditional IRA?

First, let's cover a traditional IRA and its benefits. A traditional IRA is available to anyone with earned income, including wages, salaries, commissions, taxable alimony, and self-employment income. For the purposes of an IRA, some types of income are excluded, such as earnings and profits from real estate, interest income, and pension or annuity income. 

Note that before January 1, 2020, you had to be under age 70.5 to qualify to make contributions to a traditional IRA, but that's no longer the rule. You can continue making contributions as long as you have the earned income that I just mentioned.

Another critical point is that if you don't have earned income, but you're married and your spouse does, you qualify for a spousal IRA. That means your spouse's income can be contributed to your IRA.

For 2021, you can contribute an amount equal to your (or your spouse's) earned income up to $6,000. However, if you're over age 50, you can make an additional annual "catch up" contribution of $1,000, for a total of $7,000.

What are the Benefits of a Traditional IRA?

The primary benefit of owning investments in a traditional IRA is that you don't pay tax on the money you put in the account. In other words, your contributions are tax-deductible. However, your future withdrawals of contributions and earnings are subject to your ordinary income tax rate at the time.  

Let's say you're 35 years old, earn $35,000, and file taxes as a single person. If you max out your traditional IRA by contributing $6,000 in 2021, you only pay tax on $29,000, not on $35,000. Your $6,000 IRA contribution gives you a tax savings of about $720! Every dollar that you contribute to a traditional IRA reduces your taxable income. 

One rule to know is that if you (or a spouse) participate in a retirement plan at work, you can still max out a traditional IRA; however, some or all of your contributions may not be tax-deductible, depending on your income.

One rule to know is that if you (or a spouse) participate in a retirement plan at work, you can still max out a traditional IRA; however, some or all of your contributions may not be tax-deductible, depending on your income.

As your IRA investments grow in value, you're never taxed on those earnings until you take them out of the accounts. If you owned those investments in a regular, taxable brokerage account, you'd have to pay tax on your investment gains every year.

So, a traditional IRA allows you to defer paying taxes on both your contributions and earnings until you withdraw money in the future. You can begin making distributions penalty-free once you reach the official retirement age of 59½. And you must start taking required minimum distributions (RMDs) after age 72. 

If you tap a traditional IRA before 59½, in most cases, you must pay income taxes on the withdrawal, plus an additional 10% early withdrawal penalty. That's why I never recommend breaking open your retirement piggy bank--it's just too expensive!

401(k) vs. IRA - Should You Pick One or Have Both Retirement Accounts?

What is a Roth IRA? 

Now, we'll switch gears and cover the Roth IRA. Unlike the traditional, a Roth is only available when you earn less than an annual threshold. I'll give you the details on that limit in a moment. 

For 2021, the amount you can contribute to a Roth IRA is the same as for a traditional IRA. You can put in an amount equal to your earned income up to $6,000 or $7,000 if you're over age 50. Like with a traditional IRA, you can make Roth IRA contributions no matter your age if you have qualifying earned income.  

What are the benefits of a Roth IRA?

A Roth IRA is similar to a traditional in many ways, except that it comes with different tax benefits. While the money you put in is not tax-deductible, your withdrawals are entirely tax-free! 

Using my previous example, let's say you're 35 years old, earn $35,000 and contribute $6,000 to a Roth IRA. You'd have to pay tax on your total earnings of $35,000. 

But the fantastic feature of a Roth IRA is that you'll never owe another penny in taxes, not even on the potentially massive amount of account growth that accumulated over decades! Having tax-free investment growth and retirement income is a huge deal.

Additionally, there's no rule that you must take RMDs starting at age 72, as there is with a traditional IRA. Your Roth IRA money can sit in your account forever if you wish. And you can easily pass it to your heirs. 

The last significant benefit of having a Roth IRA is that it's the most flexible type of retirement account for taking money out. Since you must pay tax upfront on your contributions, you can take them as distributions at any time.

The last significant benefit of having a Roth IRA is that it's the most flexible type of retirement account for taking money out. Since you must pay tax upfront on your contributions, you can take them as distributions at any time. Even if you're younger than 59.5, you can tap your original contributions and spend them any way you like, penalty-free.

However, there are different rules for the earnings portion of a Roth IRA because you haven't paid tax on them yet. Once you've owned the account for five years and reach age 59.5, you also qualify to withdraw earnings penalty-free. But if you're younger than 59.5, investment earnings you take out will be subject to income tax plus an additional 10% penalty.

Be aware that the Roth IRA five-year rule supersedes reaching the retirement age. In other words, even if you're over age 59.5, if you haven't owned the account for at least five years, the earnings portion of your distribution is taxable. However, once the five-year waiting period is up, you're in the clear and can make entirely tax-free Roth IRA distributions. 

To avoid violating the Roth IRA five-year rule, it's smart to open one sooner rather than later. That ensures you'll never be in a situation where you must pay tax on some of your Roth distribution.

What are the Roth IRA Income Limits?

I mentioned that you can't have a Roth IRA when you're a high earner. The upper income limit depends on your tax-filing status and modified adjusted gross income. Here are the top income thresholds to qualify for Roth IRA contributions for 2021:

  • Single taxpayers must earn less than $140,000. 
  • Married taxpayers who file jointly must earn less than $208,000.

If you qualify to contribute to a Roth IRA but find later on that your income is too high, pat yourself on the back!

If you qualify to contribute to a Roth IRA but have income that's too high later on, pat yourself on the back! It's no problem because you can keep your Roth IRA open indefinitely and enjoy its tax-free growth. However, you won't be allowed to make any new contributions unless your income dips below the annual limit in any given year.

What are the pros and cons of Traditional and Roth IRAs?

If you're eligible to contribute to either a traditional or a Roth IRA, which one should you choose? I'll summarize the advantages and disadvantages of each, so you know what's best for your situation. 

Here are the main advantages of a traditional IRA: 

  • Paying less tax. Contributions reduce your taxable income for the year--unless you or a spouse have a retirement plan at work and earn over an annual income limit.
     
  • Deferring tax. If you believe your income or tax rate in retirement will be lower than it is now, deferring tax until you make withdrawals may be a wise move. For instance, if you're middle-aged or know that your career earnings have peaked, a traditional IRA may save you money on taxes. 
     
  • Timing your future tax. You can begin taking penalty-free withdrawals and, of course, pay tax on them starting at age 59½.
     
  • Avoiding potential additional taxation. Since you only pay tax on traditional IRA withdrawals, that may give you peace of mind that your retirement funds could never be taxed twice, upfront and later on in retirement. It's not likely that double taxation on retirement accounts could pass legislation, but some worry about it. 

Now consider the main disadvantages of a traditional IRA:

  • Paying ordinary income tax rates. When you take distributions in retirement, you pay the regular income tax rate, which is higher than the long-term capital gains tax rate. In other words, investments owned in a taxable brokerage account get more favorable tax treatment than a retirement account. 
     
  • Paying RMDs. Once you reach age 72, you must begin taking withdrawals and paying taxes, even if you don't need the money in your traditional IRA. 
     
  • Paying early withdrawal penalties. If you take distributions before age 59.5, you must pay income tax plus an additional 10% penalty. However, there are some penalty exceptions, including using the funds (up to a limit) to pay for your first home, higher education expenses, medical bills, or tax delinquency.

Here are the main advantages of a Roth IRA: 

  • Avoiding future tax. Having tax-free income in retirement is something to look forward to, especially if the capital gains tax rate goes up or exceeds the ordinary income tax rate.
     
  • Paying lower taxes. If you believe you'll earn more in retirement than you do now, you can pay less tax upfront on Roth IRA contributions than traditional IRA withdrawals in the future. For instance, if you're young or just starting your career, your income and tax rate may be much lower now than when you retire.
     
  • Passing money to heirs. Since you never have to spend Roth IRA funds, you can leave them in the account for heirs.  
     
  • Making penalty-free withdrawals. You can withdraw your original contributions at any time without having to pay taxes or a penalty. And once you've owned the account for five years and reach age 59.5, you can also withdraw your account earnings penalty-free.
     
  • Avoiding conflicts with workplace retirement plans. You can max out both a retirement plan at work and a Roth IRA every year. 
     
  • Getting tax-free retirement income. Having less taxable income gives you more money to spend in retirement. Plus, it may reduce the likelihood that you'll be required to
    pay taxes on Social Security retirement benefits.

     
  • Investing on an after-tax basis. Theoretically, you should be able to invest more post-tax to a Roth IRA than a traditional account. For example, a $5,000 Roth IRA contribution would be equivalent to a traditional pre-tax contribution of $6,667, assuming a 25% tax rate. 

Now consider the main disadvantages of a Roth IRA:

  • Not getting a tax break. Since you must pay tax upfront on Roth IRA contributions, you don't get a tax break or reduce your taxable income in the year you make them. That could cause you to miss certain tax deductions and credits with qualifying income thresholds.
     
  • Paying early withdrawal penalties on earnings. Taking distributions before age 59.5 means you must pay income tax plus an additional 10% penalty on the earnings portion of your Roth IRA. As previously mentioned, there are penalty exceptions, including spending funds (up to a limit) on your first home, higher education, medical bills, or tax delinquency.
     
  • Having an unknown tax future. If the government changed the rules and tax-free withdrawals from a Roth IRA were no longer allowed, that would mean paying taxes twice. As I mentioned, that's highly unlikely, but some people believe its a Roth IRA downside.  

Should you choose a Traditional or a Roth IRA?

As you can see, a significant factor in whether you should choose a traditional or a Roth IRA depends on your future income and tax rate. Since they're impossible to know, you must make your best guestimate.

If you prefer a "bird in the hand" and want to save money on taxes sooner rather than later, a traditional IRA should appeal to you. But if you don't mind paying taxes in the current year, then a Roth IRA has many advantages.

If you prefer a "bird in the hand" and want to save money on taxes sooner rather than later, a traditional IRA should appeal to you. But if you don't mind paying taxes in the current year, then a Roth IRA has many advantages. 

And if you're still undecided, why not split your investments into both types of IRAs? You can contribute to a traditional and a Roth IRA in the same year as long as you don't exceed the annual limit. For instance, if you're under age 50, you could put $3,000 in a traditional IRA and $3,000 in a Roth IRA, or in any proportion you like, for 2021.

And a final quick and dirty tip is that if you have a workplace retirement plan and get matching funds from your employer, be sure to contribute enough to max out the match before you put any money in an IRA.

What questions do you have about retirement accounts? Leave Laura a voicemail question, comment, or idea for a future topic by calling 302-364-0308. Be sure to follow her on Instagram and learn more about her books, online courses, and free newsletter at LauraDAdams.com.

About the Author

Laura Adams, MBA

Laura Adams received an MBA from the University of Florida. She's an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura's previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.