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Finance | Secure your Retirement funding by Exploring Roth vs Traditional IRA

Secure your Retirement funding by Exploring Roth vs Traditional IRA

Roth vs Traditional IRA

Often earning individuals are found confused among Roth vs Traditional IRA. If you are a newbie and wondering what an IRA is and how these 2 types differ from each other? Don't worry, we've got your concerns covered.  An individual retirement account (IRA) serves as an ideal method to save for retirement for individuals and it can also assist in saving up on taxes as well. Though, primarily these accounts were designed for employers who don't have access to retirement plans. 

Majorly, there are 2 main types - Traditional and Roth IRA. The goals of both types are quite similar, but it differ in distinctive factors and timing to withdraw the distributions.

Traditional IRAs permit individuals to contribute a portion of pre-tax dollars. This means, through an IRA there would be a reduction in your overall taxable income for the entire year, while it sets aside funds to secure your retirement. Note, that the taxes with Traditional IRA will be on due as you decide to withdraw your money. Roth IRA permits you to contribute your post-tax dollars With Roth, there are no immediate tax savings offered but once you are retired the amount you paid and the money it earns over the years are tax-free. 

Do you want to learn more about the difference between the Roth and Traditional IRA? We will walk you through the different factors of IRA to solve your concerns like what is Roth vs Traditional IRA? Should I open a Roth or Traditional IRA  account? And more. 

What is a Traditional IRA?

Traditional IRA contributions are known to be tax-deductible on both state and federal tax returns for the entire year that you contribute. This is the reason why withdrawals also known as distributions are taxed at your income tax rate when you make, which is offered in your retirement. 

However, contributions to traditional IRAs lower your taxable income in the contribution year. This means it lowers your overall adjusted gross income (AGI), and helps you qualify for other tax incentives which you would not get otherwise. For instance, child tax credit or deduction on student loan interest. 

If you intend to withdraw money for a traditional IRA before the age of 59.5 then you will have to pay taxes and a 10% early withdrawal penalty. You can avoid the penalty but not the taxes in a few special circumstances like when you use the money to pay for being qualified for first-time home buyer expenses which is allowed up to $10,000 or if you are qualified higher education expenses. 

Additionally, permanent disabilities and certain levels of unreimbursed medical costs can be exempt from the penalty, but you will still have to pay the taxes on the distribution. 

What is a Roth IRA?

With Roth IRAs, individuals do not get tax deductions when they make the contributions, which means it does not lower your AGI of the year that pay your taxes. But, the highlighting perk of a Roth IRA includes that withdrawals received in your retirement are usually tax-free. The reason is that you paid the tax bill upfront, so you don't owe any balance amount in the backend i.e. in your retirement.

Note that Roth IRAs have certain income eligibility restrictions. As per the updated regulations of 2023, single filers must have a MAGI of less than $153,000 with contributions that phase out starting with MAGI of $138,000. Additionally, married couples should have a modified AGI of less than $228,000 to contribute to the Roth IRA, and remember contributions tend to phase out at $218,000. 

However, the limits for contributions to Roth IRA have increased in the tax year 2023. In 2022, the MAGI for single filers maxed out at $144, 000 and started phasing out at 129,000. The MAGI range for married couples who file their taxes jointly ranges from $204,000 to $214,000. 

Features of Roth IRA

If you select to go with Roth IRA, you will be amazed that it does not have any required minimum distributions (RMDs), this means you don't need to withdraw your money at any age or across your lifetime. 

This highlighting feature makes the Roth IRA an ideal wealth-transfer vehicle for individuals, and beneficiaries of this type of IRA do not owe income tax on withdrawals. Though, they need to collect the distributions or roll out the account to an IRA of their own. 

Lastly, unlike Traditional IRA, you are allowed to withdraw the sum equivalent to Roth IRA contributions which are tax and penalty-free before the due date of your tax return, for any given reason even before the age limit of 59.5 years. 

Roth vs Traditional IRA

Roth IRA vs Traditional IRAs, both offer a certain amount of tax breaks to individuals, the only distinctive factor is the matter of time when you decide to claim it. However, anyone with earned income can feasibly contribute to a Traditional IRA. Contribution being fully tax-deductible or not varies on your income or whether you or your spouse are covered by a retirement plan from your employer like 401(k). 

Another major difference between the two types of individual retirement account (IRA) lies in the method and regulations for withdrawals. If you decide to contribute to a Traditional IRA then you need to begin taking your RMDs which are set as mandatory and are taxable withdrawals of a percentage of your funds even if you do not need the money. The age limit is 73 for account owners who are born between the years 1951 to 1959 and 75 is the limit for account owners who were born in the year 1960 or later. 

Additionally, the IRS provides official worksheets to enable the calculation of your annual RMD, based on the individual's age and size of the account. 

Understanding Pre-Retirement Withdrawals

If you consider withdrawing money from Traditional IRA before the age of 59.5, then you will have to pay taxes and an early penalty on withdrawal of around 10%. You can get rid of the penalty charges (but not the taxes) in a few special situations like if you qualify for first-time home buyer expenses which is up to $10,000 or if you are qualified for higher education costs. 

Permanent disabilities and a few levels of medical costs that are not reimbursed can be exempt from the penalty, sounds too good to be true, right? But you will still have to pay the taxes on your distributions. On the contrary, Roth IRA allows you to withdraw sums equivalent to contributions which are considered a penalty and tax-free during the tax year, for any given reason even if you are below the age of 59.5 years. 

Factors to consider if you wish to withdraw your earnings

There are different regulations if you opt to withdraw your money (amount above what you contributed) from your Roth IRA. Though, if you want to withdraw your money, you can avoid a 10% penalty and taxes if you have a Roth IRA for at least 5 years and one of the below factors applies to you. 

  • You have a permanent disability
  • You meet with sudden death and money withdrawn by the beneficiary or estate. 
  • You are 59.5 years old. 
  • Utilize the money of up to $ 10,000-lifetime maximum for a first-time home purchase

If you hold the account for less than 5 years, then don’t worry you can still avoid the 10% early withdrawal penalty if:

  • Withdrawal occurs due to permanent disability or a few financial hardships. 
  • Your estate or beneficiary making a withdrawal on your death. 
  • You utilize the withdrawal money for expenses of first-time home purchase, higher educational expenses, or certain medical costs. 
  • If you are 59.5 years old. 

Understanding distinctive factors of Roth IRA vs Traditional IRA

IRA RegulationsRoth IRATraditional IRA
2022 Contribution limits$6000 - $7000 if your age 50 or older$6000 - $7000 if your age 50 or older
2023 Contribution limits$6,500 - $7,500 if you are 50 or olderSingle taxpayers who have MAGIs under $144,000 (phaseout begins at $129,000) and married couples who file jointly with MAGIs under $214,000 (phaseout begins at $204,000) are eligible for Roth IRA. 
2022 Income limitsSingle taxpayers who have MAGIs under $144,000 (phaseout begins at $129,000) and married couples who files jointly with MAGIs under $214,000 (phaseout begins at $204,000) are eligible for Roth IRA. Contributions can be made by anybody with earned income, but tax deductibility is contingent on income restrictions and participation in an employment plan.
2023 Income limitsRequired Minimum DistributionContributions can be made by anybody with earned income, but tax deductibility is contingent on income restrictions and participation in an employment plan.
Tax CreditAvailable for saver’s tax credit onlyAvailable for saver’s tax credit only
Age limitThere is no age limit on contributionsThere is no age limit on contributions
Tax TreatmentContributions are not tax deductible; earnings and withdrawals are tax-free in retirement.Tax deduction for the contribution year; withdrawals are subject to ordinary income taxes.
Required Minimum DIstributionThere are none for the account holder. The RMD rules apply to account beneficiaries.Distributions must commence at the age of 73 for account holders born between 1951 and 1959, and 75 for those born after 1960. RMD requirements apply to beneficiaries as well.
Withdrawal regulationsContributions can be withdrawn tax-free and penalty-free at any time throughout the fiscal year. Earnings withdrawals are also tax-free five years after your first deposit and at the age of 5912.Withdrawals are penalty-free after the age of 5912.
Additional benefitsAfter five years, you can take up to $10,000 in profits penalty-free to offset first-time homeowner fees. Before the age limit and five-year waiting period, qualified education and hardship withdrawals may be available without penalty.To cover first-time homebuyer expenses, you can withdraw up to $10,000 penalty-free. There are also qualified education and hardship withdrawals available.
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Difference between Roth and Traditional IRA - key factors

When you decide on selecting between a Traditional and Roth IRA, you must think of how your future income and your overall income tax bracket compare to your current situation. If you determine the tax rate that you pay on Roth IRA contributions today will be high or low compared to the distribution rates that you would pay from Traditional IRA later on. 

As per Conventional Wisdom, gross income is more likely to decline in your retirement, while sometimes taxable income does not decline. Imagine, you will be collecting and feasible owing taxes on Social Security Benefits and also you may have income on investments. In some cases, if you choose to freelance or do some consulting work then you are subject to paying self-employment tax. 

Generally, if you think you will be in a higher tax bracket in the future when you retire, Roth IRA can be an ideal option for you. Now, you will pay taxes at lower rates and can withdraw money tax-free in your retirement when you are in a higher tax bracket. 

On the other hand, if you expect to be in a lower retirement bracket in your retirement, opting for Traditional IRA would make sense financially. You can reap tax benefits today, when you are in a higher tax bracket and pay taxes later on at lower rates. 

Roth vs Traditional IRA - Distinctive elements to consider

Pretending your tax bracket in the future can be a very difficult and overwhelming decision to make. This is the reason you must understand one additional factor that will help you decide on choosing your ideal type of IRA. 

The regulations of the IRS on IRA eligibility criteria can help simplify your decision on Roth IRA vs Traditional IRA. Your income can determine a few factors:

  • Whether you are eligible for Roth IRA
  • How much of your contribution to Traditional IRA can you deduct from the current tax year? Though, the deductibility of a Traditional IRA is restricted if you or your spouse has access to a retirement plan provided at a workplace like 401(k)

Note that, you can contribute to both Traditional and Roth IRA in the same year, only if the total amount does not exceed to the maximum limit allowance to contributions which is $6,500 and $7,500 if you are 50 or older. 

Additional factors of Traditional IRA and Roth IRA

If you are still confused about these two 2 alternatives, let us walk you through the basic factors for your better understanding. 

  • The key difference between Roth IRA and Traditional IRA lies in the timing of tax advantage. 
  • Traditional IRA functions like customized pensions, in return for tax breaks they give access to funds with a few restrictions. ‘
  • Roth IRA functions like an investment account, only with a tax benefit. Comparatively, it has fewer restrictions but also has fewer tax breaks. 
  • With a Traditional IRA, you deduct contributions now and pay taxes later. And with a Roth IRA, you need to pay taxes on your contributions right now, but you benefit from contributions that are tax-free in the future. 

Should I open a Roth or Traditional IRA?

Many individuals have this concern when they are exploring both types of IRAs. To give you clarity, let us have a closer look at quick key differences so that you can seamlessly plan sources for funding for your secured retirement. 

Roth IRATraditional IRA
There is no immediate tax benefit to contributionContributions, if deductible, lower taxable income in the year they are made.
Contributions are tax-free and can be withdrawn at any time.Deductions are phased off based on income.
At higher income levels, the ability to contribute is tapered out.Retirement distributions are taxed as ordinary income.
Retirement qualified withdrawals are tax-free.Once you reach a particular age, you must make certain minimum distributions. That age was previously 72; in 2023, it increased to 73, and it will rise again to 75 in 2033.

Read Also:- A Complete Guide to Fixed Income: Types and How to Invest in Fixed Income

Difference between Roth and Traditional IRA - ultimate features

Early withdrawals are flexible with Roth IRA

Though usually early withdrawals are discouraged if you do want to break the seal for your benefit Roth allows you to withdraw contributions at any given time, without having to pay income taxes or a 10% penalty on early withdrawal. Note that, if you choose to withdraw your earnings instead of money saved in the account then the amount is taxed as capital gains. 

Whereas, traditional IRAs are not that lenient. You will have to pay a hefty penalty of 10% if you withdraw money before the age of 59.5 years, also you owe taxes at your current income tax rate on the money you decide to withdraw. 

Roth IRAs can be utilized in future estate investment planning

Whatever money is left after you withdraw, you can pass it to your beneficiaries tax-free in an inherited Roth IRA account. 

Roth IRA tends to have lower restrictions

Traditional IRAs require you to begin taking required minimum distributions (RMDs) when you reach a particular age. That age was formerly 72; it will rise to 73 in 2023 and then to 75 in 2033. 

Roth IRAs have no required minimum distribution regulations until you inherit them: You are free to leave your money in the account to grow tax-free for as long as you live.

While Roth IRAs have exceptional benefits, to have clarity, you must be aware of the perks of Traditional IRAs as well. 

Tax Deduction: Contributions to a Traditional IRA are frequently tax-deductible, which means they can reduce your taxable income for the year in which you contribute. This has the potential to reduce your existing tax liability.

Tax-Deferred Growth: Earnings or investment gains in a Traditional IRA are not taxed until they are withdrawn during retirement. Because you are not paying taxes on gains each year, your investments may increase more quickly.

Contribution Flexibility: Traditional IRAs allow you to contribute up to a specified amount each year (subject to IRS limits). This flexibility allows you to contribute more during years of high income and less during years of low income.

Contributions made before taxes: Making contributions to a Traditional IRA before taxes allows you to delay taxes.

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Can I max out the IRA limit?

Yes, you can, Even if the market is overpriced, it is worth making maximum contributions to your IRA account. The tax savings benefits you get from IRAs are far more than the slightly expensive cost of stocks, bonds, and more. 

Roth vs Traditional IRA - what should I opt for?

We have discussed the regulations and features of both types of IRAs, so selecting one alternative will depend. The key problem is deciding whether the tax rate will be more or less compared to the time you begin withdrawing funds from your account. The key solution is to consider your current tax rate and then think about whether your tax rate will be very large in the future if you are decades away from retirement. 

Make your final decision

For most people, the only advantage of a regular IRA is the tax break. This can be a major benefit for high-income workers as well as a great incentive for folks who might otherwise avoid investing for retirement. In the short term, it effectively makes saving for retirement "cheaper" because the tax savings each year reduce the cost of your contributions.

However, at the end, you will have to face a significant amount of tax burden in retirement, so unless you need that upfront tax reduction, a Roth IRA is hard to beat.

Frequently Asked Questions

Q.1 Can I contribute to Traditional IRA and Roth IRA together?

Yes, you can contribute to both a Traditional IRA and a Roth IRA in the same tax year, but both accounts have annual contribution restrictions.

Q.2 Is it possible to transfer cash from a Traditional IRA to a Roth IRA?

Yes, you can convert funds from a Traditional IRA to a Roth IRA, but you must pay taxes on the amount changed.