A Roth IRA and Traditional IRA share some similarities but differ in the way taxes are levied on the funds deposited in them. However, both offer tax savings, so they provide two great ways to save for retirement. We'll explain when to use a Roth IRA vs. a traditional IRA and how to contribute to each.
Difference Between a Traditional IRA & a Roth IRA
|Traditional IRA||Roth IRA|
|Taxes on Contributions||Pre-tax contributions||Post-tax contributions|
|2023 Contribution Limits||$6,500 yearly ($7,500 for 50 or older)||$6,500 yearly ($7,500 for 50 or older)|
|2023 Income Limits||None||Must make under $138k individually or $218k filing jointly to contribute the max|
|Withdrawal Rules||Incur 10% penalty & income tax unless 59.5 years old or above.||Incur 10% penalty & income tax unless 59.5 years old or above. Account must be open for 5+ years|
|Minimum Distributions||Required annually at age 72||None required|
Taxes for Traditional vs. Roth IRA
The biggest difference between a Roth IRA vs. a traditional IRA is when taxes are paid on the money. With a traditional IRA, contributions are tax-deductible when you put the money in. However, with a Roth, contributions are made after income taxes are paid on them. You pay income taxes on the money in a traditional IRA when you take it out in retirement, while with a Roth, distributions are tax-free because you paid income tax before you put the money in.
Traditional IRA Tax Deduction Limits
You might not be able to deduct all of your contributions to a traditional IRA in the year you put them in. As of 2023, if you file your taxes as single or head of household and do have access to a 401k or other retirement plan at work, you can deduct the entire amount up to your contribution limit if you earn up to $73,000 in modified adjusted gross income. However, if you earn between $73,000 and $83,000, you can only deduct part of it, and if you earn more than $83,000, you can't deduct any of it.
If you are married filing jointly or a qualifying widower, you can deduct the full amount if you earn up to $116,000. You can deduct part of your contributions if you earn between $116,000 and $136,000. If you earn more than $136,000, you can't deduct any of it. If you don't have access to a retirement plan at work, you can deduct the full amount of your contributions.
If you are married to someone who has access to a retirement plan at work, you can deduct the full amount of your contributions up to $6,500 (or $7,500 if over age 50) if you earn less than $218,000 or part of it if you earn between $218,000 and $228,000.
With both types of accounts, the contribution limit is $6,500 per year as of 2023 or $7,500 for those age 50 and older. These amounts change from year to year. If you contribute to multiple IRAs, you can only contribute $6,500 or $7,500 total among them all.
Income Limits to Contributions
Another key difference is income limits. With a traditional IRA, anyone with earned income can contribute, but there are income limits with a Roth, including:
- Single or married filing separately without living together: modified adjusted gross income of less than $138,000 to contribute the maximum amount or $6,500. Those who earn up to $153,000 as a single filer can contribute less than the max.
- Married and file jointly: a gross income of under $218,000 to contribute the full amount. Those making under $228,000 can contribute less than the maximum.
Roth vs. Traditional Withdrawal Rules
Roth IRAs allow you to withdraw your contributions any time, although if you withdraw the earnings on your contributions too early, there may be a 10% penalty and income taxes due. Traditional IRAs also charge a 10% penalty for early withdrawal. The withdrawal age for both is 59 and a half, although with a Roth, you must also have had the account open for at least five years. There are certain exceptions, like if you have a permanent disability or want to make a first-time home purchase.
Traditional IRAs require you to take minimum distributions starting in the year after you turn 72. The amount of these distributions is calculated by dividing the value of the account by a life expectancy factor determined by the IRS. However, Roth IRAs have no such requirement, so they are ideal for transferring wealth from generation to generation.
Tip: A traditional IRA provides tax benefits when you contribute the money, while a Roth provides a tax shelter for when you take the money out in retirement.
Benefits of a Traditional IRA & Roth IRA
The main benefit of both a traditional and a Roth IRA is the tax savings. With a Roth, the money you contribute grows tax-free because you paid taxes on it when it was deposited. However, with a traditional IRA, you get a tax break in the year you contribute the money, or today, and then you have to pay taxes when you take it out in retirement.
With a Roth, the money grows tax-free, so you don't pay taxes on your earnings unless you take them out early.
Saver's Credit Tax Break
Some low to moderate-income investors may be able to get a small tax break called the Saver's Credit in the year they contribute to their Roth or traditional IRA. The amount of the credit will be 50%, 20% or 10% of the contributions you make to an IRA up to $2,000. As such, the maximum credit is $1,000 ($2,000 if married filing jointly), and the amount you get depends on your tax filing status, adjusted gross income, and amount of contribution.
To qualify for the Saver's Credit for 2023, taxpayers who are:
- Married and filing jointly: can't earn over $73,000
- Head of household: can't earn over $54,750
- Single taxpayers: can't make over $36,500
Money for Beneficiaries with a Roth IRA
Since a Roth doesn't require you to take minimum distributions, it can serve as an excellent way to leave money to beneficiaries. If you don't need to take distributions, you can leave the money in the Roth to continue growing tax-free. When your beneficiaries take the money out after you pass away, they may not have to pay taxes on it, depending on the situation.
For example, someone inheriting a Roth from their spouse can treat it as their own, meaning they are subject to the same distribution rules as if the account were theirs to begin with. They can also open an inherited IRA using either the life expectancy method or the five-year method.
- Life Expectancy Method: they have to take minimum distributions, although they can postpone them until the later of the date the original account owner would have turned 72 or December 31 of the year following the year when the original account holder died
- Five-Year Method: they can spread out distributions but must withdraw all the money by Dec. 31 of the fifth year after the year of the original account holder's death. Earnings in an inherited IRA are taxable unless the five-year rule has been met, and the 10% early withdrawal penalty doesn't apply.
Investors who expect to leave money behind for their beneficiaries may want to consider a Roth over a traditional IRA because of the ability to transfer wealth between generations with very little taxes.
Tip: As of 2023, the contribution limit for both IRA types is $6,500 per year for those under 50 and $7,500 for those age 50 and older.
How to Choose Between a Traditional or Roth IRA
If you're wondering when to use a Roth IRA vs. a traditional IRA, it all depends on when you expect to pay more taxes. If you think you will be in a higher tax bracket in retirement than you are while working, you should opt for a Roth because you'll be paying taxes at a lower rate while you work. On the other hand, if you expect your taxable income to decline in retirement, a traditional IRA may be the best option.
A Roth might also be a better idea if you don't expect to need minimum distributions in retirement. It will enable you to leave money to your beneficiaries with a tax advantage. On the other hand, if your income makes you ineligible to contribute to a Roth, a traditional IRA may be your only option.
Tip: Choose a traditional IRA if you expect to be in a lower tax bracket when you retire or a Roth IRA if you believe you will be in a higher tax bracket when you retire.
How to Contribute to a Roth or Traditional IRA
You can fund a Roth IRA or traditional IRA through a rollover from another retirement account, including:
- Roth IRA
- Traditional IRA
- Employer-sponsored 401k plan
- Employer-sponsored 403b plan
- Government 457b plans
- SEP IRAs
- SIMPLE IRAs
However, in most cases, conversions are taxable events.
After the account is established and funded, you can contribute to it via wire transfer or check. You can contribute the entire amount at the beginning of the tax year or set a plan to automatically contribute throughout the year. You have until April 15 the following year to contribute for each tax year.
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