Roth or Traditional IRA. What's the Difference?

Roth or Traditional IRA. What's the Difference?

March 26, 2024

Question:

Roth IRA & Traditional IRA. How do they work and what are the differences?

Answer:

No matter what age you are or how much money you have, there isn’t a better time than now to start saving for retirement.

We get questions all the time as financial advisors about individual retirement accounts and which options might be best for our clients. Depending on your life circumstances, there are a few different types of individual retirement accounts (IRAs) that you can use to prepare for retirement.

The two that we will talk more about today are the Roth IRA and Traditional IRA. Below, we talk further about each of these types of accounts, their similarities and differences and how they can help you prepare for your future.

Traditional IRA:

Let’s start off with a Traditional IRA. These accounts allow individuals to save for retirement with tax-deferred growth on any potential investment earnings. This means that during your years of contributing to this account, you will be able to claim those contributions on your taxes to help potentially minimize your tax liability for that year.

In the same breath, it also means that when you are allowed to start withdrawing money from the account, you will be taxed on those withdrawals.

Roth IRA:

Now, let’s discuss a Roth IRA. There are many similarities between both of these accounts, which we discuss below, however the key difference is in the timing of the taxation of your money. For a Roth IRA, you contribute to the account with post-tax dollars, meaning that you can not claim those contributions on your annual taxes.

However, a huge difference is that your withdrawals from a Roth IRA are tax free meaning that the amount you see in the account when you can start withdrawing is yours without liability.

Not everyone can open up a Roth IRA as there are certain income restrictions to these accounts. Per the IRS website, in 2024 “the income phase-out range for taxpayers making contributions to a Roth IRA is increased to between $146,000 and $161,000 for singles and heads of household, up from between $138,000 and $153,000. For married couples filing jointly, the income phase-out range is increased to between $230,000 and $240,000, up from between $218,000 and $228,000. The phase-out range for a married individual filing a separate return who makes contributions to a Roth IRA is not subject to an annual cost-of-living adjustment and remains between $0 and $10,000.”*

One other caveat of a Roth IRA is that you can only start making withdrawals after the account has been open for 5 years to avoid a penalty tax.


Similarities between a Roth and Traditional IRA:

With that being said, let’s talk about some of the key features of these accounts that are the same for both a Traditional and Roth IRA.

First let’s start off with the types of investments you can make.

One of the most attractive features of IRAs is that the investment scope is quite broad when compared to employer sponsored accounts such as 401ks or 403(b)s. In an IRA, you can investment in Stocks, Bonds, ETFs and Mutual Funds while 401ks and 403(b)s mainly just offer mutual funds.


Now, let’s move to the contributions:

For IRAs there are certain contribution limits that you will have to adhere to on an annual basis. For 2024, that limit is $7,000. If you are over the age of 50, you would be able to deposit an additional $1,000 as a catch-up contribution for your retirement savings. These numbers tend to change on an annual basis so it is important to always stay up to date on what each year will bring.


Next, let’s talk about withdrawals:

An IRA is designed to be used in your retirement years and thus, there are certain restrictions to when you can start to utilize the funds without incurring a penalty.

You can start to make your withdrawals, penalty free, at age 59 ½. At this point if you have a traditional IRA, you will pay ordinary income tax on your withdrawals. Your Roth withdrawals are tax free.


Withdrawals before age 59 ½:

Here’s where things differentiate for Traditional and Roth accounts. 

For Traditional IRA’s: Any withdrawals taken prior to age 59 ½ are subject to a 10% penalty on top of the taxes owed on that full withdrawal.

For Roth IRA’s: Any withdrawals taken prior to age 59 ½ are subject to a 10% penalty on top of the taxes owed on any earnings in the account. You can withdraw your contributions at any time tax and penalty free (since you technically already paid taxes on it).

There are extenuating circumstances or in other terms, hardship withdrawals that can be made from the account prior to 59 ½ that will avoid that 10% penalty tax. These include but are not limited to, a first-time home buyer withdrawal, unreimbursed qualified medical expenses or to pay for higher education. There are certain limits to these withdrawals which you can find out more about here: https://www.irs.gov/retirement-plans/hardships-early-withdrawals-and-loans

 

The final word:

We always encourage our clients to add a form of retirement account, outside of their employer-sponsored one, as a means of supplemental retirement funding. Depending on your financial situation, either of these accounts could be right for you. The nice thing is that setting up these accounts is generally a pretty seamless process.

Our advice to our clients is to maintain periodic contributions throughout each year and to try to hit the maximum deposit amount annually. From there, monitor your investments and let the power of compounded interest take its course!

Do you have questions you would like us to discuss here? Click this link to let us know and we hope you found this helpful!

*Source: https://www.irs.gov/newsroom/401k-limit-increases-to-23000-for-2024-ira-limit-rises-to-7000