What’s the Difference between a Traditional IRA and a Roth IRA (and Which One Is Best for You)?

There are subtle yet significant differences between traditional IRAs and Roth IRAs. You may know a few of them, but many differences are known only to tax experts and financial advisors. But a little knowledge of the difference between these two valuable retirement savings plans can go a long way.

Differences between a Traditional IRA and Roth IRA

So we’re all on the same page, let’s first discuss the basics. “IRA” stands for Individual Retirement Account. Both Roth and Traditional IRAs are retirement accounts individuals can open in addition to accounts available through their employers.

Traditional IRAs allow savers to deposit funds into the account each year. In 2017, the contribution limit is $5,500 for people under 50 years old and $6,500 for those 50 and older. These deposits and contributions are tax deductible for nearly all investors. Traditional IRA savings grows tax-free. You’re permitted to withdraw funds without penalty once you turn 59 ½. All monies you withdraw from a traditional IRA are taxable income. 

Let’s assume for a minute that you contributed $5,000 a year for 20 years. And let’s assume you earned 8.14% on your investment over those 20 years. At the end of the 20 years, you would have $250,000 in your traditional IRA. You contributed $100,000 ($5,000 a year for 20 years) and took $100,000 in income tax deductions during the 20 years. The $100,000 you invested earned you $150,000 of profit. If, at the end of the 20 years, you retired and withdrew $20,000 from your traditional IRA, you would pay income taxes on that withdrawal. The remaining funds in your traditional IRA would continue to grow tax-deferred until you made another withdrawal.

Though the contribution limit is the same, Roth IRAs work a bit differently than traditional IRAs do. Contributions are NOT tax deductible. So, using the example above, you would pay taxes on each $5,000 contribution you made over 20 years. Assuming 8.14% earning each year, the balance in your Roth IRA will also grow to $250,000. Unlike the traditional IRA, however, withdrawals after age 59 ½ are taken tax-free. If you took a $20,000 withdrawal when you retired, you’d pay no income tax on that $20,000.

Subtler—and Potentially Valuable—Differences

The significant differences outlined above are just two of several potential valuable distinctions. Use the subtler differences between these two accounts to maximize both the growth and utility of their savings.

  Traditional IRA Roth IRA
Withdrawal Penalties If you withdraw money from your traditional IRA before age 59 ½ and without a reason permitted by IRS, you pay both income tax and a 10% penalty on the entire withdrawal. If you withdraw money from your Roth IRA before age 59 ½ and without a reason permitted by IRS, you don’t pay tax or penalty on any contribution portion (the money you initially deposited).
Tax Rates Because your traditional IRA funds are taxed when you take the money out of the account, they are taxed at the tax rate where you live when you’re taking withdrawals. Because your Roth IRA funds are taxed when contributed, your Roth is taxed at the state tax rate for the state where you live while you’re making the contributions.
Contributions You may only contribute to a traditional IRA until you reach age 70 ½. You can contribute at any age.
Income Limits You can contribute to a traditional IRA regardless of your annual earnings. Your opportunity to contribute to a Roth IRA stops once your earnings reach a certain amount.

As these subtle differences imply, factors such as relocating to another state, the need to withdraw IRA contributions for unique reasons other than retirement, and your income itself all play a part in the Roth IRA v. traditional IRA decision.

GuideSource has an accounting practice steeped in tax strategy knowledge. This knowledge allows us to help our clients build tax plans to maximize the dollars they keep while maintaining the flexibility our clients need. We take pride on adding value for our clients as opposed to the traditional tax services where clients pay a fee for the service of tax return preparation. Contact us to learn more about the GuideSource difference and why GuideSource is Where Wisdom Is for Hire.