Roth IRA vs. Traditional IRA: A Comprehensive Comparison

The sooner that you’re able to start planning for retirement, the better off you’ll be. With the power of consistent savings and market growth, you’ll likely be set up for a relaxing retirement. When it comes to saving for retirement, you have many different individual retirement account options. Two of those options include the Roth IRA and the traditional IRA. Knowing the difference between the two will help you make the right financial decision.

What Is A Traditional IRA Vs. Roth IRA?

With a traditional IRA, contributions are made with pretax dollars that grow tax-deferred, but early withdrawals (prior to age 59.5) from the account are taxed as income. With a Roth IRA, contributions are made with taxed dollars that grow tax-free, but withdrawals after age 59.5 can typically be made tax- and penalty-free.      

• Traditional IRA: With a traditional IRA, you get a tax deduction immediately in the year you make a contribution. That can lower your taxable income right away, but you'll pay income taxes on any gains when you withdraw the money in retirement.
• Roth IRA: When contributing to a Roth IRA, you don't get a tax deduction in the year you contribute. Instead, your contributions and any gains accumulate tax-free. When you withdraw your funds in retirement, you won't pay any taxes in most cases.

Traditional IRA And Roth IRA Contribution Limits

Both the traditional IRA and Roth IRA limit how much you can contribute each year. Both types of individual retirement accounts have the same limits. In 2022, you can contribute up to $6,000 into a retirement account. That's $6,000 total – you can choose which type of IRA to contribute to but you can't contribute $6,000 into a traditional IRA AND $6,000 into a Roth IRA.

You can make additional catch-up contributions if you are age 50 or older. Those in that age bracket have a contribution limit of $7,000 in 2022. If your taxable compensation or earned income for the year is less than the contribution limit, you can only contribute up to the total of your earned income for the year.

Traditional IRA Vs. Roth IRA: Key Differences

Here are some of the key differences between a Roth IRA and a Traditional IRA:

Eligibility Requirements

Both types of IRA require you to have earned income in order to contribute. You can never contribute more than the amount of earned income that you have in a year.

• Traditional IRA: There are no income limits to contribute to a traditional IRA, but those with higher incomes may not qualify for the tax deduction (see below)
• Roth IRA: The Roth IRA restricts high-income individuals from opening a Roth IRA. How you file tax returns each year (married filing jointly, single, head of household, married filing separately, etc.) affects the income contribution limit.

Tax Breaks

Both types of IRA offer tax breaks, but the tax breaks work in a slightly different way.

• Traditional IRA: Your contributions are tax deductible for the year you make the contribution, subject to income limits. This can lower your taxable income and adjusted gross income, saving you money in taxes each year.
• Roth IRA: You will not receive a tax deduction for the contributions you made that year. Instead, you pay taxes on the money upfront, which means that you won't pay them on withdrawals.

Early Withdrawal Rules

Since IRAs are designed as retirement accounts, there are rules (and often penalties) if you withdraw the money before retirement age.

• Traditional IRA: If you withdraw money before age 59.5 from your traditional IRA, it will be taxed at your current income tax rate. You'll also be charged a 10% early withdrawal penalty.
• Roth IRA: Your contributions can be withdrawn at any age tax- and penalty-free. If you withdraw any earnings before age 59.5 and owning the account for at least five years, they will be taxed at your current income tax rate and charged a 10% early withdrawal penalty. There are a few exceptions to this rule, such as using the money for qualified higher education expenses, buying your first home or excess medical expenses.

Required Minimum Distributions

Depending on the type of IRA, you may be subject to required minimum distributions (RMD) regulating how and when you make withdrawals in retirement.

• Traditional IRA: Withdrawals become mandatory starting at age 72. The IRS has a formula for how to calculate your annual RMD, based on your age and the size of your account.
• Roth IRA: A Roth IRA has no required minimum distributions.

How To Choose Between A Roth IRA And A Traditional IRA

Here are a few things you'll want to keep in mind to help you choose between a Roth IRA and a Traditional IRA account.

1. Check Your IRA Eligibility

One of the first steps you'll want to look at is whether you qualify for either one though IRS guidelines. Your age, income level and whether you have an employer-sponsored 401(k) plan all affect your eligibility. If you don't qualify for a Roth IRA, you might consider a backdoor Roth IRA.

2. Consider Your Future Income Tax Bracket

The next thing to consider is your future income tax bracket. If you're younger with many years for retirement, it can be hard to know exactly what your tax bracket will be 40 or 50 years down the road. Still, it’s important to think about; there may be a higher tax rate on Roth IRAs contributions today or a higher rate on distributions from traditional IRAs later. Generally, the younger you are (and the lower your income is), the more a Roth IRA makes sense.

3. Work With A Brokerage Firm

You can't start either a traditional or Roth IRA on your own — you'll need to work with a brokerage firm. There are many different options including a discount brokerage where you are in charge of all investment decisions, a robo advisor or a full-service brokerage.

The Bottom Line

Both a traditional IRA and a Roth IRA can be great options to save for retirement. No matter which you choose, the sooner you start investing and putting the power of compound interest to work for you, the better off you'll be in retirement. For more information to help you plan for your financial future, check out the resources available on the Rocket HQ^SM Learning Center.