Figuring out the best way to invest money for retirement can be challenging. If you’re considering opening an individual retirement account (IRA) account, the good news is that an IRA can be an excellent retirement savings vehicle.
Both traditional and Roth IRAs could be useful retirement accounts, depending on your situation. Here is a look at these two types of IRAs, how they work, and whom they’re best for.
Roth vs. traditional IRA: A quick comparison
|Roth IRA||Traditional IRA|
|Tax on contributions||Contributions are after-tax; there are no upfront tax benefits||Contributions are generally pre-tax, potential tax deduction in the current year|
|Tax on withdrawals||No (with some exceptions)||Yes (with some exceptions)|
|Mandatory withdrawal age (RMDs)||Not required||Required starting at age 72|
|Early withdrawal penalties||Withdraw contributions tax-free and penalty-free any time, but pay taxes and 10% penalty on earnings withdrawals before age 59 1/2||Pay taxes and 10% penalty on any withdrawal before age 59 ½, except in certain cases like for a first-time home purchase or for qualified education costs|
|Loans||Not available||Not available|
|Income limits||Only single filers with MAGIs under $140,000 and married couples filing jointly with MAGIs under $208,000 can contribute.||Anyone with earned income can contribute, but contributions aren't tax deductible above certain income limits.|
|Annual contribution limit (for tax year 2022)||
Roth IRA: The basics
Roth IRA accounts have their own unique rules around contribution limits, taxes, and withdrawals. Roth IRA contributions can be made up to the annual limits set by the IRS, which are $6,000 for those who are under 50 and $7,000 for those who are 50 or over in 2022.
Contributions are also made on an after-tax basis, which means your tax benefits will be deferred until you make withdrawals in retirement. And provided that your Roth IRA has been open for at least five years, any contributions you make can be withdrawn tax-free if you are at least age 59 1/2. That five-year rule also applies to money converted to a Roth IRA. You can withdraw your contributions tax-free as long as you completed your rollover five years ago and you’re at least 59 1/2.
Unlike with a traditional IRA account, there are no RMDs with a Roth IRA. This is one of the key advantages of a Roth IRA over a traditional IRA account, which requires RMDs beginning at age 72. Another benefit is that qualified distributions can be made tax-free and penalty-free. These conditions must be met in order for a distribution to be considered qualified:
- You must have satisfied the five-year rule and reached age 59 1/2.
- The distribution is being made because you have become disabled.
- The distribution is being paid to your beneficiaries upon your death.
- The distribution meets the requirements for a first home and is less than $10,000.
It’s also important to note that if you are over 59 1/2 but have not met the five-year requirement, non-qualified distributions will be taxed, but you won’t need to pay the 10% early withdrawal penalty. If you are under 59 1/2 and your account hasn’t been open for five years, any non-qualified distributions will be subject to both taxes and a 10% penalty. However, withdrawing your own contributions to the account won’t result in taxes or penalties; they apply only when you withdraw investment gains.
To contribute to a Roth IRA account, your income must be under certain thresholds based on modified adjusted gross income (MAGI). For 2022 these MAGI thresholds are:
|Filing status||MAGI||Contribution limit|
|Married filing jointly or qualifying widow(er)||Less than $204,000||$6,000 for those under 50
$7,000 for those 50 or over
|Between $204,000 and $214,000||Phased contribution limits|
|Over $214,000||No contributions allowed|
|Single, head of household, married filing separate (did not live with spouse during the year)||Less than $129,000||$6,000 for those under 50
$7,000 for those 50 or over
|Between $129,000 and $144,000||Phased contribution limits|
|Over $144,000||No contributions allowed|
|Married filing separate but lived with spouse at any point during the year||Between $0 and $10,000||A reduced amount|
|Over $10,000||No contributions allowed|
Roth IRA pros
- Qualified withdrawals are not subject to taxes or a 10% penalty.
- Potential earnings in the account can grow-tax free
- No required minimum distributions.
- Inherited Roth IRA accounts are not taxable to account beneficiaries, provided the original account holder had met the five-year rule prior to their death.
Roth IRA cons
- There are income limitations, which may impact your ability to contribute to a Roth IRA or limit your contributions.
- Contributions are limited to the overall limits for IRA contributions for the year.
Traditional IRA: The basics
As with Roth IRAs, you can make traditional IRA contributions up to the total annual IRA contribution limits. For 2022, these limits are $6,000 for those under age 50 and $7,000 for those 50 or over at any point during the year. Total contributions across both Roth and traditional IRA accounts can’t exceed those limits.
Contributions to a traditional IRA are typically made on a pre-tax basis, assuming you meet certain requirements, which we’ll discuss in a minute. Because contributions are most often pre-tax and tax-deductible in the year they're made, withdrawals are generally subject to ordinary income taxes at the time of the withdrawal, unlike qualified withdrawals from a Roth IRA account. In the case where after-tax contributions have been made to an IRA, the value of those contributions is not subject to taxes. However, it’s important for you to keep track of any after-tax contributions to be able to exclude them come tax time.
If you make withdrawals from a traditional IRA prior to age 59 1/2, they are generally subject to a 10% early withdrawal penalty in addition to any income taxes due. Exceptions to the 10% penalty include:
- Withdrawals due to the death of the account holder
- Withdrawals due to the disability of the account holder
- Withdrawals to cover health insurance premiums while you are unemployed
- Withdrawals for qualified educational expenses for the account holder, their spouse, or their child
- Withdrawals up to $10,000 to cover certain expenses related to a first-time home purchase
- Withdrawals by a member of the national guard or a military reservist if called to active duty
- Withdrawals to cover unreimbursed medical expenses in excess of your adjusted gross income
Unlike with a Roth IRA, traditional IRA accounts are subject to RMDs, which currently start at age 72 for those who had not reached age 70 1/2 prior to Jan. 1, 2020.
If you’re covered by a workplace retirement plan like a 401(k) and your income exceeds a certain amount, your ability to deduct your pre-tax contributions in the current year is limited. Here’s how your income impacts your allowable deductions if you have a retirement plan through your employer:
Note: If you are not covered by an employer retirement plan, these limitations do not apply.
|Filing status||MAGI||Tax deductibility|
|Married filing jointly or qualifying widow(er)||Less than $109,000||Contributions are fully deductible, up to the contribution limit|
|Between $109,000 and $129,000||Contributions are partially deductible|
|Over $129,000||Contributions aren’t tax-deductible|
|Single or head of household||Less than $68,000||Contributions are fully deductible, up to the contribution limit|
|Between $68,000 and $78,000||Contributions are partially deductible|
|Over $78,000||Contributions aren’t tax-deductible|
|Married filing separate||Less than $10,000||Contributions are partially deductible|
|Over $10,000||Contributions aren’t tax-deductible|
Traditional IRA pros
- The ability to make tax-deductible contributions, in certain cases, which can offer a tax break in the current year.
- Potential earnings can grow tax-deferred until withdrawn in retirement.
- Anyone with earned income can contribute. Your contributions cannot be more than the amount of your earned income for the year.
- Since the implementation of the SECURE Act legislation, there are no age limits prohibiting contributions as long as you have sufficient earned income. The prior limits prohibited contributions to a traditional IRA after age 70 1/2.
Traditional IRA cons
- Accounts are subject to RMDs.
- The ability to make pre-tax contributions may be limited or prohibited totally if your income is too high and you are covered by a workplace retirement plan.
- Withdrawals are often counted as taxable income in retirement.
How to choose between a Roth IRA and a traditional IRA
The choice between a Roth or traditional IRA for saving for retirement, including one or the other, both, or neither, will depend on your unique circumstances. Factors to consider include:
- What your tax bracket is now versus what it might be when you reach retirement. For example, if you think you will be in a high tax bracket in retirement, a Roth IRA can offer tax benefits once you reach retirement and allow for more planning options.
- Consider whether the opportunity for tax benefits today from pre-tax contributions or the opportunity for tax-free withdrawals in retirement is more beneficial for you.
It can also make sense to have both types of IRA accounts. With tax rates currently at relatively low levels, Roth conversions from traditional IRA accounts are a strategy that many are considering. Having assets in both a traditional and Roth IRA can provide tax diversification and help with tax planning once you reach retirement.
Which is better, a Roth or traditional IRA?
Whether a Roth or traditional IRA is a better retirement savings account for you depends on your situation. Issues such as your current tax rate versus your anticipated tax rate in retirement should be considered. For instance, if you expect to be in a higher tax bracket when you retire, a Roth IRA might be a better option for you.
Other potential questions to ponder as you think about your options: Do you need to diversify your retirement savings? Will a Roth account, with its tax-free withdrawals and no RMDs be beneficial for your estate planning needs? Would you benefit more from the immediate tax savings that generally comes with a traditional IRA?
Does it make sense to have both a Roth IRA and a traditional IRA?
Again, the answer depends on your situation and personal finance goals. Having both IRA types could potentially provide tax benefits when you retire, as nobody knows what the future holds as far as tax rates and changes in the rules.
Roth IRAs have some advantages in terms of passing this account on to beneficiaries who are not your spouse under the current rules. As long as the five-year rule was met by the original account holder, the beneficiaries can take distributions from a Roth IRA tax-free. Both types of accounts could potentially aid in your overall retirement planning, depending on your situation.
Should you convert your traditional IRA to a Roth IRA?
Converting a traditional IRA to a Roth IRA is a strategy that has received a lot of publicity in the financial press over the past couple of years. This is due to the historically low tax rates in place since the tax reform rules that went into effect during the 2018 tax year.
Before converting your traditional IRA to a Roth IRA, it makes sense to crunch the numbers in terms of the taxes you’ll pay in the year of the IRA conversion versus the long-term benefits you’ll realize from tax-free withdrawals in the future. You’ll also want to be sure to have enough money outside the traditional IRA to cover any taxes on the conversion; otherwise, this could be a very expensive proposition.
Can you contribute to both a Roth and a traditional IRA?
The answer to this question is yes, as long as your total IRA contributions to both types of accounts do not exceed the total IRA contribution limits set by the IRS for that year. The contribution limits for 2022 are $6,000 for those under 50 and $7,000 for those who are 50 at any point during the year. These limits apply to total IRA contributions for both IRA types.
The bottom line
Depending on your situation, either or both a Roth and traditional IRA account can be useful as part of your overall retirement and financial planning efforts.
If you’re struggling with how to invest money for retirement, it could make sense to consult with a fee-only financial advisor to get professional advice and ensure you’re not making a costly mistake in this area. If you’re ready to start investing for retirement, check out our picks for the best brokerage accounts.
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