IRA stands for individual retirement account, and for years it only came in one flavor, now known as “traditional.” The IRA offered a tax-advantaged way to save for retirement, and it came with some good benefits and some tight restrictions.
Then came the Roth IRA, which works opposite, similarly, and differently than a traditional IRA.
How they’re opposite: In a traditional IRA, the money you put in is tax-deductible, and the money you take out during retirement is taxable. With a Roth IRA, you don’t get a tax deduction for the money you put in, and you don’t pay any taxes on the money you pull out.
How they’re similar: Both types of IRAs let your money grow tax-deferred, meaning you don’t pay taxes on earnings as you earn them. And both allow for a penalty-free withdrawal of $10,000 for a first time homebuyer.
Three ways they’re different:
- With a traditional IRA, those earnings get taxed when you take the money out. In a Roth IRA, the earnings don’t get taxed – ever – as long as you take the withdrawals properly.
- You can’t touch the money in a traditional IRA without penalty until you hit IRS-dictated retirement age, currently 59½. As long as you wait five years before taking money out of your Roth IRA, you won’t have to pay any penalties – but you may have to pay taxes on some of the earnings.
- Once you hit age 70½, you have to take money out of your traditional IRA whether you want to or not. You never have to take money out of the Roth IRA, but your heirs must.
How can you tell which is better for you? Here’s the key deciding factor: the expected tax rate when you retire. If you expect your tax rate to be lower when you retire, a traditional IRA makes a better choice. But if you think your tax rate will be the same or higher than it is now, a Roth IRA is the hands-down winner.
Now, of course, federal tax rates can be unpredictable, and depend a lot on who’s in office during your retirement. But part of your tax rate depends on you: If your income will be much lower in retirement than it is now, you can be pretty sure your tax rate will be lower, too.
Keep in mind that all of these rules are based on the current tax law (as of December 2016). If anything changes, we’ll talk about it here.
In a nutshell…
|Feature||Traditional IRA||Roth IRA|
|Maximum contributions 2016-17||$5,500
$6,500 if you’re over 50
$6,500 if you’re over 50
|Contribution limits||N/A||Yes, based on income|
|Deduction limits||Depends if you can contribute to a retirement plan through your job||N/A, all contributions are taxable|
|When can you take money out without penalty?||Beginning at age 59½||5 years after the first contribution is made or at age 59½|
|Earnings taxed?||Tax-deffered||Tax-free in many circumstances|
|Required minimum distributions?||Yes, starting at age 70½||None (unless the account holder dies)|
For more detailed information about Roth IRAs and taxes, click here.
For more detailed information about traditional IRAs, penalties, and taxes, click here.
Those links come with a BORING WARNING, but the information is 100% reliable.