Understanding Traditional and Roth IRAs: What You Need to Know

IRAs, or Individual Retirement Accounts, are special type of investment accounts designed to help you build your retirement nest egg and set aside money for later in life. These types of accounts are really designed for the long-term, allowing you to save and invest money over a long period of time for your future. IRA accounts also offer some important tax benefits that can end up saving you thousands of dollars over the long term.

Though some employers offer IRA options, the more common retirement account option through your employer would be a 401(k). IRAs are more typically a type of retirement account taken on by an individual, usually to help supplement retirement savings in other accounts, like a 401(k). Here’s what you need to know about them:

Photo by Michael Longmire on Unsplash

There are two main types of Individual Retirement Accounts: the Roth IRA and the traditional IRA. Though they are similar, there are several important differences between them, including income limits, contribution limits, and tax benefits.

Both traditional and Roth IRAs have the same contribution limits, currently $6,000 each year or $7,000 if you are over age 50. You can have both a traditional and a Roth IRA, but the contribution limits are cumulative, not specific to each type of account. Early withdrawals from your IRA, whether it’s a Roth or traditional IRA, are typically subject to a 10 percent early withdrawal fee, though in certain cases that does not apply.

For example, you can withdraw money from your traditional IRA accounts to help with certain college expenses, and you can withdraw up to $10,000 towards the purchase of your first home without a penalty. Keep in mind that although you will not be charged the early withdrawal penalty, you will still need to pay taxes on the withdrawals.

You can also withdraw any funds you have contributed to your Roth IRA to help with college expenses or anything else you desire without any penalties. However, any withdrawals of earnings on investments could be subject to taxes.

Both traditional IRAs and Roth IRAs can be made up of a variety of different investments. These can include various stocks, bonds, and mutual funds, among others. Anyone that is currently employed can open an IRA account, regardless of whether or not you already have a 401(k) through an employer. This makes IRAs a great option to supplement your retirement savings from an additional source.

A traditional IRA offers tax deferment on all your contributions, which means that you will save money in the short term. Your contributions to a traditional IRA are not taxed until you actually withdraw the funds during your retirement. Contributing to your traditional IRA can lower your taxable income for the year since they are tax deductible. This may help you to qualify for other tax incentives you might not have otherwise received.

However, keep in mind that you may end up paying a higher tax rate during your retirement. This is because your withdrawals will be taxed at whatever the current income tax rate is. With traditional IRAs, you must begin withdrawing the money before you reach the age of 70 1/2. This means, among other things, that you can only delay paying income tax on the funds for so long.

A Roth IRA, on the other hand, is funded with after-tax dollars. While this means they are more expensive up front, you will save money during retirement, since at that time funds are withdrawn tax-free. Your Roth IRA might be the only source of tax-free income you have as a retiree, and that’s a good thing!

There are also no limits as to how long funds can stay in a Roth IRA account. This can make a Roth IRA a great source of transferring wealth, since the funds don’t need to be withdrawn during the account owner’s lifetime. Those who inherit a Roth IRA also do not pay income tax on the money, though they are required to either take the distributions from the account or roll over the funds into an IRA that they own themselves.

As an individual for the year 2020, you must have a modified adjusted gross income (MAGI) that totals less than $139,000 in order to contribute to a Roth IRA. Phasing out of contributions begins with a modified adjusted gross income of $124,000. As a married couple, your modified adjusted gross income must be less than $206,000, and that same phasing out begins if your MAGI is $196,000.

Contribution limits for traditional IRAs depend largely on whether you have access to a retirement plan at work. If both you and your spouse do not have access to a retirement account through your work, you may both contribute up to the limit regardless of income. However, if you or your spouse are covered by a retirement plan at work and exceed certain income thresholds, then deductions on your contributions may be limited.

As of 2020, there are no age limits on contributing to either traditional or Roth IRAs.

Choosing between a Roth and traditional IRA depends somewhat on your current income (due to income restrictions), but you should also consider how you think your future income will compare to what you are experiencing right now. This is related to your anticipated future tax bracket.

If you think you will be in a higher tax bracket during retirement, a Roth IRA is likely the better choice for you. If you expect to be in a lower tax bracket, then a traditional IRA may be the better choice.

Robert Ryerson authored the 2016 book What’s the Deal With Identity Theft?: A Plain English Look at Our Fastest Growing Crime.

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