Traditional IRA vs Roth IRA

My name is Joseph Reinke and as an expert with more than two decades of experience in finance, I have had the privilege of guiding thousands of new grads in managing over $2.6 billion in assets and debt. This journey has given me invaluable insights into the intricacies of investing and debt management.

One question that comes up often is the choice between a Traditional IRA vs. a Roth IRA. In this article, we will go into these two types of IRAs, shedding light on their unique advantages, tax implications, and suitability for different financial situations.

What are Traditional and Roth IRAs?

Traditional IRA

A Traditional Individual Retirement Account (IRA) is a type of retirement savings account that offers advantageous tax benefits to the account holder. Contributions made to a Traditional IRA may be tax-deductible in the year they are made, depending on your income and participation in an employer-sponsored retirement plan. The investments within the account grow tax-deferred, meaning you won’t pay taxes on the earnings until you start withdrawing funds.

Withdrawals from a Traditional IRA can begin at age 59 1/2 without penalty. However, they are subject to income tax at your then-current rate. If withdrawals occur before age 59 1/2, they are typically subject to a 10% early withdrawal penalty, barring some exceptions. By age 72, account holders are required to start taking minimum distributions (RMDs) from the account, which are also subject to income tax.

Roth IRA

A Roth IRA (Individual Retirement Account), unlike a Traditional IRA, offers tax benefits on the back end, making it an attractive option for those who anticipate being in a higher tax bracket during retirement. In a Roth IRA, contributions are made with after-tax dollars, meaning there’s no immediate tax break. However, these contributions and the earnings derived from them can be withdrawn tax-free during retirement.

Withdrawals from a Roth IRA are permitted without penalty after age 59 1/2, provided the account has been open for at least five years. Unlike a Traditional IRA, a Roth IRA does not require mandatory minimum distributions (RMDs) at any age, allowing account holders to let their investments continue to grow tax-free. Early withdrawals of contributions (not earnings) are also possible without penalties or taxes, offering more flexibility compared to the Traditional IRA. However, early withdrawal of earnings may be subject to income tax and a 10% penalty, unless an exception applies.

Key Differences between Traditional IRA and Roth IRA

Eligibility and Contribution Limits

Eligibility Criteria for Traditional IRA and Roth IRA

Traditional IRA

Eligibility for a Traditional IRA is relatively straightforward. Anyone with earned income who is younger than 70 1/2 years old can contribute to a Traditional IRA. This includes wages, salaries, bonuses, tips, and self-employment income, among others. There is no income limit for contributing to a Traditional IRA, making it accessible to earners at all income levels.

Roth IRA

In contrast, Roth IRAs have eligibility requirements based on your modified adjusted gross income (MAGI) and tax filing status. For 2024, if you’re single or head of household, you can make a full contribution to a Roth IRA if your MAGI is less than $161,000.

For married couples filing jointly, the income limit for a full contribution is $240,000. If your MAGI exceeds these limits, you cannot contribute to a Roth IRA. There are no age restrictions on making contributions to a Roth IRA as long as you have earned income.

In both cases, the maximum contribution for 2024 is $7,000, or $8,000 if you’re age 50 or older.

However, you may still contribute to a Roth IRA regardless of your income via a backdoor Roth IRA.

Phase-Out Ranges for Traditional IRA and Roth IRA

Traditional IRA

For a Traditional IRA, the ability to deduct your contributions can phase out if you or your spouse has a retirement plan at work and your income exceeds certain levels. In 2024, for single filers or heads of household who are covered by a workplace retirement plan, the phase-out range is between $77,000 and $87,000. For married couples filing jointly where the spouse making the IRA contribution is covered by a workplace retirement plan, the phase-out range is $123,000 to $143,000. The range for a non-active participant spouse is $230,000 to $240,000.

Roth IRA

The ability to contribute to a Roth IRA is also subject to phase-out ranges based on your modified adjusted gross income (MAGI). In 2024, for single filers or heads of household, the phase-out range is $146,000 to $161,000. For married couples filing jointly, the phase-out range is $230,000 to $240,000. Within these ranges, the ability to contribute to a Roth IRA gradually reduces until it is eliminated entirely at the upper end of the range.

Tax Treatment and Deductions

Tax Deductions for Traditional IRA

In a Traditional IRA, contributions are made with pre-tax dollars, which means they are tax-deductible in the year they are made. This immediate tax break can potentially lower your overall taxable income, effectively reducing the amount of income tax you owe for that year. For example, if you contribute $6,000 to a Traditional IRA, and you’re in the 24% tax bracket, you could reduce your tax bill by $1,440 ($6,000 x 24%).

However, it’s important to note that the ability to deduct Traditional IRA contributions is subject to income limits if you or your spouse is covered by a workplace retirement plan. The deductibility of your contributions is phased out once your income exceeds certain limits (as detailed in the “Phase-Out Ranges for Traditional IRA” section), until it is eliminated entirely at the higher end of the range.

Therefore, while the Traditional IRA offers an immediate tax deduction, the eventual tax bill is deferred to the time of withdrawal. At that point, both the initial contributions and any earnings are subject to income tax at your then-current rate. This structure can be beneficial if you anticipate being in a lower tax bracket during retirement compared to your current tax bracket.

Tax-Free Growth in Roth IRA

Unlike a Traditional IRA where taxes are deferred until withdrawal, Roth IRA contributions are made with after-tax dollars. This means that you don’t receive an immediate tax deduction on your contributions. However, one of the significant advantages of a Roth IRA is the opportunity for tax-free growth. As your investments grow in a Roth IRA, the earnings are not subject to income tax or capital gains tax.

This allows the money in your Roth IRA to compound over time without being diminished by taxes. Furthermore, when you start making qualified withdrawals in retirement, both your contributions and the earnings on those contributions are tax-free. As long as the account has been open for at least five years and you are aged 59 1/2 or older, you can withdraw the funds without owing any taxes. This feature allows Roth IRA holders to have a clear picture of their retirement savings, as the balance in the account is the exact amount they can spend.

Case Studies

Examples of FitBUX Members Opening Traditional or Roth IRAs

Example 1: Opening a Traditional IRA

Take the case of James, a 40-year-old FitBUX member. He’s currently in the highest tax bracket, earning over $500,000 per year. Expecting his income to decrease significantly after retirement, he opts for a Traditional IRA. With this account, he can deduct his contributions on his tax returns now and pay taxes on the withdrawals at a potentially lower rate after retirement.

Example 2: Opting for a Roth IRA

Then we have Sarah, a 25-year-old FitBUX member who recently graduated with her DPT. Currently, she earns $70,000 annually, falling into a relatively modest tax bracket. She expects her income to increase in the future, putting her in a higher tax bracket at retirement. Therefore, Sarah chooses a Roth IRA, where she pays taxes now at her current lower rate, and she can enjoy tax-free withdrawals in her retirement.

Example 3: Choosing a Traditional IRA with a Workplace Retirement Plan

Let’s now take a look at Robert. He earns $85,000 per year and is covered by a retirement plan at work. Due to his work retirement plan, his ability to deduct Traditional IRA contributions phases out after $64,000. However, he can still contribute to a Traditional IRA without a tax deduction, and his earnings will grow tax-deferred until he withdraws them at retirement.

Frequently Asked Questions

1. The main difference lies in the tax structure of these two types of IRAs. Contributions to a Traditional IRA are made with pre-tax dollars and are tax-deductible in the year they are made. However, you will have to pay taxes when you withdraw the funds in retirement. On the other hand, Roth IRA contributions are made with after-tax dollars. You do not receive a tax deduction when you make the contributions, but your withdrawals in retirement are tax-free.
   2. Yes, you can contribute to both types. However, the total combined amount you contribute to all your IRAs (both Traditional and Roth) can’t exceed the annual limit ($8,000 in 2024 if you’re age 50 or older, or $7,000 if you’re under 50).
      3. If you withdraw funds from your Traditional IRA before age 59 1/2, you may have to pay a 10% early withdrawal penalty in addition to the regular income tax. However, there are certain exceptions for specific situations like buying a first home or paying for qualified education expenses. For a Roth IRA, you can withdraw your contributions at any time without paying taxes or penalties, but withdrawing earnings may result in taxes and penalties unless you meet certain criteria.
         4. Yes, this is known as a “Roth conversion” and it allows you to transfer funds from a Traditional IRA to a Roth IRA. You’ll have to pay taxes on the amount transferred since Traditional IRA contributions are pre-tax and Roth IRA contributions are post-tax. As for the reverse scenario, transferring from a Roth IRA to a Traditional IRA, while technically possible, is rarely beneficial due to the tax implications and is therefore not commonly done.
            5. Traditional IRAs require minimum distributions once you reach age 72. However, Roth IRAs do not have any required minimum distributions during the owner’s lifetime. This difference can significantly impact your retirement and estate planning strategies.

               Conclusion

               In conclusion, both Traditional and Roth IRA offer unique advantages tailored to different financial situations and retirement goals. The Traditional IRA allows for tax-deductible contributions and tax-deferred growth, making it a viable choice if you currently find yourself in a high tax bracket and foresee being in a lower one upon retirement. On the other hand, the Roth IRA, with its after-tax contributions and tax-free growth, could be a better fit if you expect to be in a higher tax bracket when you retire. It’s important to remember that each person’s situation is unique, and what works for one may not work for another.

               If you have any questions about Traditional or Roth IRAs, or if you’re unsure which route is the best for your financial future, don’t hesitate to reach out to us at FitBUX. Our team of experts is more than happy to help guide you through the complexities of retirement planning. Schedule a call with us today and let’s start planning for your future together.