Traditional individual retirement accounts (IRAs) and Roth IRAs are popular choices for retirement savings, but with clear differences in terms of how your contributions are taxed. Let’s take a look at how each one operates so that you can make the right decision between a traditional IRA vs. a Roth IRA based on your retirement needs.
Smart IRAs: Up-Front Information on Retirement Choices
It’s never too early to start saving for retirement, even if you are already making contributions at work. While traditional IRAs and Roth IRAs are similar products, they offer very distinct benefits regarding how contributions are taxed. This can make a big difference, depending on your current financial situation and what it will be when you retire.
Traditional IRAs
A traditional IRA is a personal version of the IRA you might have at work—without any employer contributions, of course. Designed for business owners, contractors, and others without retirement benefits, a traditional IRA allows you to make tax-free contributions. You are then taxed on your total contributions plus interest when you make withdrawals after you retire.
You can contribute to a traditional IRA no matter how much you earn each year.
A traditional IRA allows you to:
- Make contributions without paying state or federal tax
- Earn tax-deferred interest on your total account balance
- Take penalty-free distributions after age 59-1/2
- Pay tax on distributions at your post-retirement tax rate.
You can contribute up to $6,000 to a traditional IRA every year and up to $7,000 a year after age 50. If you choose to withdraw funds before you reach 59-1/2 years of age, you will pay the tax due on the amount you withdraw plus a 10% penalty, although there are some exemptions for health emergencies, education expenses, and first-time home purchases.
There are also no income-eligibility restrictions. You can contribute to a traditional IRA no matter how much you earn each year. Finally, while withdrawals are voluntary from age 59-1/2, they become mandatory after age 72.
Pros of a Traditional IRA
In general, traditional IRAs are simple to understand and easy to set up, with potential advantages that include:
- No tax on contributions
- No annual tax on interest as you earn it
- Pre-tax deductions lower your taxable income (and potentially your bracket) each year
Cons of a Traditional IRA
At the same time, it’s important to be aware of some ways in which your traditional IRA might not always work to your benefit, including:
- You will be taxed on your contributions AND interest earned AFTER you retire
- You will pay a penalty plus any tax due on funds you withdraw early
- You can only contribute a limited amount each year
Roth IRAs
Roth IRAs are designed to act more like investment accounts, with greater flexibility combined with some of the benefits of structured retirement saving. A Roth IRA allows you to contribute any amount of after-tax income to your interest-bearing account in return for tax-free payouts of your earnings plus interest after retirement.
A Roth IRA allows you to:
- Make unlimited contributions after paying state and federal taxes
- Earn tax-free interest on your total account balance
- Withdraw contributed amounts tax and penalty-free at any time
- Enjoy tax-free earning withdrawals after the age of 59-1/2
You do need to meet or fall below a certain adjusted gross income to qualify for a Roth IRA. For 2022, single tax filers need to earn less than $144,000 with some restrictions for income above $129,000. Joint filers need to earn less than $214,000 with increasing restrictions on contributions for those earning more than a joint $204,000.
If you meet these requirements, Roth IRAs are a great way to build tax-free wealth with no limits on after-tax contributions and no mandatory withdrawals. You will, however, likely face a higher annual income tax bill because you will not be able to deduct your contributions.
Roth IRAs are a great way to build tax-free wealth with no limits on after-tax contributions and no mandatory withdrawals.
It’s also important to understand the difference between your contributions to a Roth IRA and the interest you earn on those contributions over time. While your contributions can be withdrawn without paying either tax or a penalty, you will be taxed and charged up to 10% on early withdrawals of interest with certain conditions.
Pros of Roth IRAs
Roth IRAs offer significant practical and tax advantages, especially when used to supplement traditional work or private IRA accounts. Key benefits include:
- Unlimited annual contributions
- Tax-free interest on your contributions
- Penalty-free withdrawals of your contribution (but not interest)
- No mandatory withdrawals
Cons of Roth IRAs
The greater flexibility of Roth IRAs also comes with some potential downsides, depending on your situation. These can include:
- Minimum income requirements
- A bigger annual tax bill (potentially in a higher tax bracket)
- Restrictions and tax on early earnings withdrawals
Which Plan Is Right for You?
In general, a traditional IRA offers many of the benefits of a pension plan in a private savings account that you can invest in as you see fit. Conversely, a Roth IRA offers much of the flexibility of a true investment account, with significant tax advantages in exchange for some restrictions on how and when you can access your money.
Choosing between a traditional and a Roth IRA requires an understanding of how the taxation rules of each will affect you at different stages of your life.
With taxation when funds are distributed to you after retirement, a traditional IRA is probably better if you expect to fall into a similar or lower tax bracket after you retire.
If you expect to earn a similar salary for the rest of your career, a traditional IRA will reduce your taxable income now and allow you to defer paying tax on your retirement savings plus interest until you receive the funds.
With tax paid up front and no restrictions on how much you can pay in each year (provided you meet income requirements), a Roth IRA makes sense if you expect your total income to put you in a higher tax bracket after retirement than you’re currently in. By accepting a higher tax bill now, you’ll get the maximum benefit of tax-exempt interest growth.
For more ways to maximize the impact of your Roth IRA, check out this post.
The flexibility of IRA accounts also means you’ll be able to tap your contributions with no penalty should you need to, with some restrictions on interest earned. And, with no withdrawal requirements, you can leave your tax-free nest egg invested until you or your beneficiaries need it—making it a great way to build intergenerational wealth.
Get Retirement Right With Radiant Credit Union
Saving for retirement is a critical part of your overall financial plan. Whether you want the security and predictability of a traditional IRA or the flexibility and growth potential of a Roth IRA, Radiant Credit Union has the right retirement savings product to meet your needs.
At Radiant we can help our members plan for the future with a tax-deferred traditional IRA or build long-term wealth with a flexible, tax-free Roth IRA. Click below to learn more.