Is it Better to Have a Traditional IRA or ROTH IRA?

Regularly investing using one or more tax-advantaged retirement accounts is wise if you want a financially comfortable retirement. I’m a big fan of individual retirement accounts or IRAs because they’re available to just about anyone, regardless of age. You could be a teenager with a job, an employee of a small company that doesn’t offer a retirement plan or even an unemployed spouse of a breadwinner and still qualify for an IRA.

Is it better to have a traditional IRA or ROTH IRA?

However, understanding the differences between a traditional and a Roth IRA and which one is right for you can be confusing. This post will review the updated IRA rules, explain who qualifies to use them, and which is better for your financial situation and goals.

What is an Individual Retirement Account (IRA)?

An important concept to understand about an IRA, or any retirement account, is that it’s not an investment. An IRA is an account where you own your investments to get preferential tax treatment.

I think of a retirement account like your house or apartment. It shelters and protects you, but it isn’t you. Similarly, an IRA is just a shelter that protects your investments from taxation while you own them inside the account.

The contributions you make to an IRA get allocated to your chosen investments. However, if you open an IRA and never choose investments, your contributions just sit in a holding account and earn nothing, so don’t make that mistake!

Depending on the firm’s menu, you can own many investments in an IRA. They might include stocks, exchange-traded funds (ETFs), mutual funds, index funds, certificates of deposit (CDs), and money market funds.

If you open a self-directed IRA, you can even own alternative investments in your account, like real estate, businesses, gold, or cryptocurrency. If you want to learn more, listen to Money Girl podcast 813, What Is a Self-Directed IRA (SDIRA)?. But we’re just going to focus on traditional and Roth IRAs here.

What is a Traditional IRA?

First, let’s cover a traditional IRA. It’s available to anyone with earned income, including wages, salaries, commissions, taxable alimony, and self-employment income. For the purposes of an IRA, some types of income are excluded, such as earnings and profits from real estate, interest income, and pension or annuity income.

Before 2020, you had to be under 70.5 to qualify to contribute to a traditional IRA, but that’s no longer the rule. Now, you can make traditional IRA contributions as long as you have the types of earned income that I just mentioned.

Another IRA feature that many people don’t know about or take advantage of is called a spousal IRA. It’s not a different type of account, but the ability for your spouse to max out an IRA on your behalf if you’re married and don’t have earned income. For instance, if you’re unemployed or a stay-at-home parent, your spouse’s income can max out your traditional or Roth IRA.

What are the benefits of a Traditional IRA?

The primary benefit of owning investments in a traditional IRA is that you don’t pay tax on the money you put in the account. In other words, your contributions are tax-deductible. However, your future withdrawals of contributions and earnings are subject to your ordinary income tax rate at the time.

For 2024, you can contribute an amount equal to your (or your spouse’s) earned income up to $7,000. However, if you’re over 50, you can contribute an additional $1,000 or $8,000.

Let’s say you’re 35, earn $50,000 yearly, and file taxes as a single. If you max out your traditional IRA in 2024 by contributing $7,000, you only pay income tax on $43,000, not on $50,000. Every dollar you contribute to a traditional IRA reduces your taxable income, which is a nice benefit.

As your IRA investments grow, you only pay tax on the earnings once you withdraw them. Owning investments in a taxable brokerage account means paying annual tax on any investment gains. With a traditional retirement account, your profits are only taxed at some point in the future.

So, a traditional IRA allows you to defer paying tax on your contributions and earnings until you make future withdrawals. You can begin taking penalty-free distributions after the official retirement age of 59.5. You must start taking required minimum distributions (RMDs) after age 73 (or 75 beginning in 2033).

If you tap a traditional IRA before 59.5, in most cases, you must pay income tax on the withdrawal, plus an additional 10% early withdrawal penalty. That’s why I never recommend breaking open your retirement piggy bank–it’s too expensive!

One rule to know about traditional IRAs is that if you (or a spouse) participate in a retirement plan at work, like a 401(k) or 403(b), you can still max out a traditional IRA; however, some or all of your contributions may not be tax-deductible, depending on your income.

What is a Roth IRA?

Unlike a traditional IRA, you can only contribute to a Roth IRA when you earn less than an annual threshold, which I’ll review in a moment. If you qualify, you can make Roth IRA contributions with qualifying earned income, regardless of age.

For 2024, the contribution limit for a Roth IRA is the same as a traditional IRA. It’s equal to your (or your spouse’s) earned income up to $7,000 or $8,000 if you’re over 50.

However, if you earn too much to qualify for a Roth IRA, you can make Roth conversions, which I explain in podcast 768, Too Rich for a Roth IRA? 3 Legal Ways to Have One. I’ll also review the strategy in a moment.

What are the benefits of a Roth IRA?

A Roth IRA is similar to a traditional IRA in many ways, except how it’s taxed. You make after-tax, non-deductible contributions and can make tax-free withdrawals in retirement.

Using my previous example, let’s say you’re 35, earn $50,000 a year, and contribute $7,000 to a Roth IRA. You’d have to pay tax on your total earnings of $50,000.

However, you’d never have to pay tax on the account again–even if your Roth IRA mushrooms with massive investment growth. Skipping taxes on growth and enjoying tax-free income in retirement is a huge deal!

Additionally, there are no RMDs with a Roth IRA, as with a traditional IRA. Your Roth IRA funds can stay in the account and easily get passed to your heirs.

Another significant Roth IRA benefit is that it’s less punitive for taking early withdrawals before age 59.5. Since you pay tax upfront on Roth contributions, you can take them as penalty-free distributions anytime. However, withdrawals of earnings would be subject to taxes plus a 10% penalty if you’re younger than 59.5.

Be aware that Roth IRAs have a rule that you must own the account for five years before qualifying to withdraw your earnings penalty-free, no matter your age. Therefore,

I recommend opening a Roth IRA sooner rather than later, even if you can only make a small contribution.

That ensures you’ll never be in a situation where you must pay tax on the earnings portion of a Roth IRA distribution because you still need to satisfy the five-year ownership requirement.

What are the Roth IRA income limits?

I mentioned that you can’t have a Roth IRA when you earn over an annual threshold. The limit depends on your tax filing status and modified adjusted gross income (MAGI).

Here are the 2024 income limits to qualify for a Roth IRA:

Single taxpayers must have a MAGI of less than $161,000 but qualify for a reduced contribution from $146,000 to $160,000. You can make a full contribution with MAGI under $146,000.
Married taxpayers filing jointly must have a MAGI of less than $240,000 but qualify for a reduced contribution from $230,000 to $239,000. You can both make full contributions with MAGI under $230,000.
Married taxpayers filing separately can use the single limits if they haven’t lived together in the past year.

If you qualify to contribute to a Roth IRA but become ineligible in the future, you can keep your account indefinitely and enjoy its tax-free growth. However, you can only make new contributions if your income dips below the annual allowable limit.

What are the pros and cons of Traditional and Roth IRAs?

Which should you choose if you’re eligible to contribute to a traditional or Roth IRA? I’ll summarize the pros and cons of each account so you know what’s best for your situation.

Here are the primary advantages of a traditional IRA:

Paying less tax: Traditional contributions reduce your taxable income for the year–unless you or a spouse have a retirement plan at work and earn over an annual income limit.
Deferring tax: If you believe your income or tax rate in retirement will be lower than it is now, deferring tax until you make withdrawals may be a wise move. For instance, if your career earnings have peaked, using a traditional IRA cuts your taxes by delaying them until you earn less and are in a lower tax bracket.
Timing your future tax: You can begin taking penalty-free withdrawals and, of course, pay tax on them starting at age 59.5
Avoiding potential double taxation: Since you only pay tax on traditional IRA withdrawals, that may give you peace of mind that your retirement funds could never be taxed twice, upfront and in retirement. It’s not likely that double taxation on retirement accounts could pass legislation, but some worry about it.

Now consider some disadvantages of a traditional IRA

Paying RMDs: Once you reach age 73, you must begin taking traditional IRA withdrawals and paying taxes, even if you don’t need the money.
Paying early withdrawal penalties: If you take distributions before age 59.5, you must pay income tax plus an additional 10% penalty. However, some penalty exceptions include using the funds (up to a limit) to pay for your first home, higher education expenses, medical bills, or tax delinquency.

Here are the main advantages of a Roth IRA:

Avoiding future tax: Having tax-free income in retirement is something to look forward to, especially if rates go up.
Paying lower taxes: If you believe you’ll earn more in retirement than now, you can pay less tax upfront on Roth IRA contributions than on future traditional IRA withdrawals. For instance, if you’re young or just starting your career, your income and tax rate may be much lower now than when you retire.
Passing money to heirs: Since you never have to spend Roth IRA funds, you can leave them in the account for heirs.
Making penalty-free withdrawals: You can withdraw your original contributions anytime without paying taxes or a penalty. And once you’ve owned a Roth IRA for five years and reached age 59.5, you can also withdraw your account earnings penalty-free.
Avoiding conflicts with workplace retirement plans: You can max out a retirement plan at work and a Roth IRA every year. As I mentioned, you can also max out a traditional IRA, but your contributions may not be partially or fully deductible, depending on your income.
Getting tax-free retirement income. Having less taxable income gives you more money to spend in retirement. Plus, it may reduce the likelihood that you’ll be required to pay taxes on Social Security retirement benefits or be subject to other income-driven surcharges.
Investing on an after-tax basis: Theoretically, you should be able to invest more post-tax to a Roth IRA than pre-tax to a traditional account. For example, a $5,000 Roth IRA contribution would be equivalent to a traditional pre-tax contribution of $6,667, assuming a 25% tax rate.

Now consider the main disadvantages of a Roth IRA:

Not getting a tax break: Since you must pay tax upfront on Roth contributions, you don’t get a tax break or reduce your taxable income in the same year. That could cause you to miss certain tax deductions and credits with qualifying income thresholds.
Paying early withdrawal penalties on earnings: Taking distributions before age 59.5 means you must pay income tax plus an additional 10% penalty on the earnings portion of your Roth IRA. As previously mentioned, penalty exceptions include spending funds (up to a limit) on your first home, higher education, medical bills, or tax delinquency.
Having an unknown tax future: If the government changed the rules and no longer allowed tax-free withdrawals from a Roth IRA, that would mean paying taxes twice. That’s highly unlikely, but some people believe it’s a Roth IRA downside.

Should you choose a Traditional or a Roth IRA?

As you can see, a significant factor in choosing a traditional or a Roth IRA depends on your future income and tax rate. Since they’re impossible to know, you must make your best guess.

If you prefer a “bird in the hand” and want to save money on taxes sooner rather than later, a traditional IRA should appeal to you. But if you don’t mind paying taxes in the current year or want as much tax-free income in retirement as possible, then a Roth IRA has many advantages.

And if you’re still undecided, why not split your investments into both types of IRAs? You can contribute to a traditional and a Roth IRA in the same year if you don’t exceed the annual limit. For instance, if you’re under age 50, you could put $3,500 in a traditional IRA and $3,500 in a Roth IRA, or in any proportion you like, for 2024.

An important tip is that if you have a workplace retirement plan and get matching funds from your employer, be sure to contribute enough to max out the match before you put any money in an IRA. Also, remember that there are no income limits to qualify for a workplace account like a Roth 401(k)–a Roth IRA is the only account where your income can keep you from participating.

LISTEN: Roth IRA vs Roth 401(k)–10 Differences Investors Should Know

What is a Roth Conversion?

I mentioned that doing a Roth conversion is a way to fund a Roth IRA even if you earn too much for contributions. A Roth conversion differs from a contribution because funds come from a pre-tax source, such as a traditional IRA, 401(k), or SEP IRA, instead of an after-tax source. That means doing a Roth conversion triggers income taxes you must be prepared to pay.

For example, if you want to convert $50,000 from your traditional IRA to your Roth IRA, your annual taxable income increases by $50,000. If you’re in the 22% tax bracket, you’d owe up to $11,000 on the conversion–but it could be more if the extra income pushes you into the next higher tax bracket.

Another difference is that unlike Roth IRA contributions, which come with an income limit, Roth conversions have no income limit. Additionally, Roth conversions have no contribution limit. You can convert as much as you like from traditional to Roth accounts each year, and the IRS will happily take your income taxes, no matter how much you earn!

That’s why it’s wise to do Roth conversions when you have a lower-income year and even when the value of your investments is down. Many people do conversions in the so-called “gap” years after they retire and earn less but before their RMDs begin.

Everyone’s situation and retirement plans are different, so you should seek guidance from a financial advisor or tax professional before converting because you can’t reverse them if you change your mind.

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