Retirement Accounts: Roth vs. Traditional IRA

You've probably heard of an IRA and chances are someone has recommended you begin one. But where do you start? What is the difference between Roth and Traditional? We're here to help.

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Today we’re going to break down a key component of retirement planning: Individual Retirement Accounts, better known as  "IRA"s. Not only will we demystify what IRAs are, but we will also dive into the differences between the two main types: Roth and Traditional IRAs.

What Is an IRA?

In its simplest form, an IRA is an account set up at a financial institution that allows an individual to save for retirement with tax-free growth or on a tax-deferred basis. It is important to note that an IRA is NOT the same as a 401K plan, which is company sponsored and not self-directed like an IRA. The primary benefit of an IRA is the tax treatment, thereby enhancing your ability to grow your retirement nest egg.

There are several types of IRAs—Traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs. Each offers different advantages, but today, we're going to focus on Traditional and Roth IRAs, as they're most common for individuals. 

What can you do with an IRA?

The primary purpose of an IRA is to save and invest for retirement, but these accounts can serve other financial needs as well (some well before retirement). Here are a few potential uses of an IRA:

• Retirement savings: The primary purpose of an IRA is to accumulate funds for your retirement years. It provides a tax-advantaged way to grow your savings and build a nest egg for the future.

• Tax diversification: Having a mix of pre-tax and post-tax retirement savings can offer flexibility when it comes to managing your tax liability in retirement. By having both a Traditional IRA and a Roth IRA, you can create a tax-diversified retirement strategy.

• Education expenses: In some cases, you can use IRA funds to pay for qualified higher education expenses for yourself, your spouse, children, or grandchildren without incurring the early withdrawal penalty. However, taxes may still apply to the withdrawn amount.

• First-Time Home Purchase: One of my favorites benefits of an IRA is that you can withdraw up to $10,000 of capital gains penalty free if you are a qualified first-time home buyer.  This includes buying, building or rebuilding a first-time home.  This is a MASSIVE advantage and can save you a meaningful chunk of taxes that allows your money to go further.  

Early Withdrawals and Exceptions

While IRAs are designed for retirement savings, there may be circumstances where you need to access the funds before reaching retirement age. It's important to note that early withdrawals from IRAs usually come with penalties and taxes and is almost always ill-advised.

If you withdraw funds from a Traditional or Roth IRA before the age of 59 ½, you generally face a 10% early withdrawal penalty in addition to income taxes on the withdrawn amount. However, there are exceptions to this penalty. Some exceptions include using the funds for qualified higher education expenses, purchasing a first home, paying for unreimbursed medical expenses, and certain other hardships.

Traditional IRAs: Tax Relief Today

A Traditional IRA offers tax advantages that can benefit you now. Here's how it works:

• Tax deductions: Depending on your income and whether you or your spouse has a retirement plan at work, your contributions to a Traditional IRA may be tax-deductible in the year they are made. This reduces your taxable income, potentially lowering your tax bracket.

• Tax-deferred growth: Investments in your Traditional IRA grow tax-deferred, meaning you won't pay taxes on the growth until you withdraw the funds during retirement. 

• Taxed withdrawals: When you make withdrawals from your Traditional IRA in retirement, typically after age 59 ½, the withdrawals are taxed as ordinary income. 

Roth IRAs: Tax-Free Growth and Withdrawals

Roth IRAs offer a different tax approach that can be advantageous in the long run. Here's how they work:

• After-tax contributions: Contributions to a Roth IRA are made with after-tax dollars, so you don't get a tax deduction for your contributions in the year they are made.

• Tax-free growth: Similar to a Traditional IRA, investments in your Roth IRA grow tax-free. The growth is not subject to taxes when you make withdrawals in retirement, provided certain conditions are met.

• Tax-free withdrawals: Once you reach age 59 ½ and have held the Roth IRA for at least five years, withdrawals, including the earnings portion, are tax-free.

Choosing the Right IRA for You

Deciding between a Traditional IRA and a Roth IRA depends on your current and future tax situations. Here are some key considerations:

Roth IRA may be ideal if:

• You expect to be in a higher tax bracket during retirement.

• You prioritize tax-free growth and tax-free withdrawals.

• You have the ability to make after-tax contributions without the immediate tax deduction.

Traditional IRA may be ideal if:

• You expect to be in a lower tax bracket during retirement.

• You want tax deductions on contributions, reducing your taxable income now.

• You don't mind paying taxes on withdrawals in retirement.

Comparison Overview

Our pick: Roth IRA 

There is a reason there are income limitations in order to contribute to a Roth IRA.  In general, it is extremely likely that taxes continue to increase for all income brackets.  Our personal view is that personal finances is about controlling what you can control.  In the case of a Roth IRA, you know exactly the tax rate and pay it up-front, whereas in a Traditional IRA, there is a degree of uncertainty with regard to future tax rates. 

To demonstrate our point, if you are taxed at the exact same rate today as you would at retirement, your net earnings would be exactly the same between a Roth and Traditional IRA.  So unless you sincerely believe your tax bracket will be lower, it is probably best to elect a Roth IRA.

Maxing Contributions and Rollovers

Of course, if you work for a company that has a 401K matching program or another beneficial government or company sponsored plan, please evaluate these options before considering contributions to your IRA.

If you have the means to do so and already considered and/or took advantage of other work/government sponsored retirement benefits, it is a fantastic idea to maximize your IRA contributions (both types if you can).  While we recommend first maxing your Roth IRA, if you above the income threshold or have already maxed your Roth IRA, it is also a great idea to then maximize your Traditional IRA

It is also important to note that you can rollover your Traditional IRA into a Roth IRA and then realize the benefits realized in a Roth.  This topic expands beyond the scope of this comparison, but we will be doing an additional write up on rollovers to guide you through this process/decision. 

Do your Research

Choosing the right IRA is a significant decision that should be part of your overall retirement planning strategy. It's crucial to consider your current financial situation, future income expectations, and tax implications. Please conduct your research accordingly. 

Conclusion

Whether you opt for a Traditional IRA or a Roth IRA, both accounts offer valuable benefits for retirement savings. By understanding the tax advantages and considering your individual circumstances, you can make the right choice. Remember, your financial future is in your hands. Take action now, select the IRA that aligns with your goals, and watch your retirement savings grow.

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