Traditional IRA vs. Roth IRA: Which One Should You Choose?

When it comes to saving for retirement, two of the most popular options are the Traditional IRA and the Roth IRA. Both offer tax advantages, but they work in different ways.

How do you decide which one is right for you? Let’s break it down in simple terms.

How They’re Taxed

Traditional IRA:

• Tax Break Now: When you contribute to a Traditional IRA, you might get a tax deduction for the amount you put in. There are specific rules around deduction eligibility based on your filing status and Modified Adjusted Gross Income (MAGI).
• Taxes Later: The money you put in grows tax-deferred, which means you don’t pay taxes on it until you withdraw it in retirement. However, when you do take it out, you’ll pay taxes on both the contributions and the earnings at your then ordinary tax rate.

Roth IRA:

• No Tax Break Now: Contributions to a Roth IRA are made with money that’s already been taxed, so you don’t get a tax deduction.
• Tax-Free Later: The big benefit is that when you withdraw the money in retirement, both your contributions and any earnings are tax-free. No taxes, ever again, on that money!

When You Can Take Money Out

Traditional IRA:

• Rules for Taking Money Out: Once you hit age 73, you’re required to start taking out a minimum amount each year (this is called a Required Minimum Distribution, or RMD).
• Early Withdrawals: If you take money out before age 59½, you might have to pay a 10% penalty on top of regular income taxes, though there are some exceptions.

Roth IRA:

• No Forced Withdrawals: You’re not required to take any money out during your lifetime. You can let it grow as long as you like.
• More Flexibility: You can withdraw your contributions (but not earnings) anytime without taxes or penalties. If you meet certain conditions, even the earnings can be withdrawn tax-free.

How Contributions Work

For 2024, you can contribute up to $7,000 per year to a Traditional or Roth IRA. If you’re 50 or older, you can contribute up to $8,000 thanks to catch-up contributions. You can contribute to both in the same year, but not exceeding the limit in either account. There is a penalty for over-contributing – 6% of the excess amount for each year those dollars remain in the IRA!

There are various strategies for managing contributions, including Roth IRA Conversions and Backdoor Roth Contributions. Including these in your wealth management plan can be beneficial when implemented correctly and at the right time. As an example, beware the pro-rata rule.

Income Limits for Contributions

Traditional IRA:

• Anyone can contribute, but whether your contribution is tax-deductible depends on your filing status, income, and whether you have a retirement plan at work.

Roth IRA:

• There are income limits for contributing. In 2024, single filers have income phase outs starting at $146,000 through the max $161,000. Married filing joint have income phase outs starting at $230,000 through the max $240,000. If your MAGI is higher than the phaseout limit, you are not eligible to contribute.

Tax Considerations

Traditional IRA:

• If you think you’ll be in a lower tax bracket in retirement, a Traditional IRA could be a good option because you get the tax break now.

Roth IRA:

• If you expect your tax rate to be higher in retirement or if you think tax rates will go up, a Roth IRA might make more sense since you pay taxes now and enjoy tax-free withdrawals later.

Planning for the Future

Traditional IRA:

• You’ll need to plan for paying taxes on your withdrawals in retirement, which could impact your budget.
• Withdrawals increase taxable income in the year made, which can impact the amount of taxation on Social Security benefits, as well as Medicare Part B premiums.

Roth IRA:

• Offers tax-free income in retirement, giving you more control over your money.

Other retirement accounts:

• If you are a business owner or have a retirement plan option through your employer, there may be other account types and considerations to know. Click here to see our downloadable 2024 retirement plan guide.

Estate Planning

Your Traditional IRA and/or Roth IRA should have a named beneficiary designation. The account will pass to your named beneficiary(ies), and there are varying rules for spouse vs non-spouse inheritors. The SECURE Act mandated that non-spousal beneficiaries must withdraw all the funds from an inherited IRAs within 10 years.

Your estate planning attorney and financial advisor can help you understand the pros and cons of other strategies, such as naming a charity or your Trust as your beneficiary.

Which One Should You Choose?

Deciding between a Traditional IRA and a Roth IRA depends on your current financial situation and your expectations for the future. If you’re looking for a tax break now and expect to be in a lower tax bracket in retirement, a Traditional IRA might be your best bet. On the other hand, if you prefer tax-free income in retirement and expect to be in a higher tax bracket later on, a Roth IRA could be the way to go.

And remember, it’s not an either-or situation. Many people choose to contribute to both types of IRAs to diversify their tax strategy. Retirement planning is all about making choices that align with your future goals and pre-defined purpose.

Your financial future is too important to leave to chance. We can help you define your financial purpose and ongoing financial health monitoring. Click here to see our approach and schedule time to meet.

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