Whether to use a traditional or a Roth IRA is a decision anyone saving for retirement with an IRA must make. Both types of IRAs allow you to accumulate significant funds for retirement, but each provides different tax advantages. The answer to the question of “Which is the better IRA for me?” is not the same for everyone. The answer depends on an individual’s income, current tax bracket, future tax bracket, marital status, etc. The answer in many cases is that both types will provide valuable benefits.
A traditional IRA allows an individual who has earned income and is under age 70½ to make potentially tax-deductible annual contributions. You can contribute any amount up to $5,500 for 2017 ($6,500 if you are 50 or older). One of the main incentives for making annual contributions to a traditional IRA is the ability to take a tax deduction, which depends on whether you or your spouse participate in a retirement plan at work and your level of income. Another important feature is that traditional IRAs can accept rollovers from your workplace retirement plan when you change jobs or retire. This allows you to continue growing these savings on a tax-deferred basis, as well as consolidate your pre-tax retirement savings into one account.
You can take distributions from an IRA at any time. Distributions are generally taxable in the year of the distribution (and subject to a 10% penalty if you are not yet 59½). When you reach 70½, you must begin taking a minimum distribution from your traditional IRA each year (i.e., begin paying tax on those tax-deferred dollars).
A traditional IRA may be a good choice if you:
- Would like a tax deduction for your retirement contributions
- Believe you will be in a lower tax bracket at retirement than you are now
- Have income above the limits permitted to contribute to a Roth IRA
- Are receiving a taxable distribution from an employer’s retirement plan and want to continue to defer taxation on your savings and investment earnings
A Roth IRA allows an individual with earned income to make after-tax contributions, subject to the same annual contribution limits as a traditional IRA. There is no age limit for being eligible to contribute to a Roth IRA, but you must have income within certain limits. You may not take a tax deduction for a Roth IRA contribution.
Roth IRAs can also receive rollovers. You can roll over assets from a designated Roth account in a 401(k) plan or 403(b) plan to a Roth IRA in a tax-free transaction. You can also roll over your pre-tax accounts in an employer plan to a Roth IRA. Pre-tax assets rolled over to a Roth IRA are taxable in the year they are distributed from the employer plan. Once the pre-tax assets are converted to Roth status, these assets are treated as basis (after-tax assets) in the Roth IRA and are subject to the Roth distribution rules.
Roth IRAs also allow distributions at any time, but the taxation of a Roth distribution is different from that of a traditional IRA distribution. You will never be taxed on a distribution of your annual Roth contributions or pre-tax assets that have been rolled over to your Roth IRA. The earnings in the Roth IRA will also be distributed tax-free if the distribution is a “qualified distribution.” This is one of the most important benefits of a Roth IRA: the potential for tax-free growth of investment earnings. A distribution is qualified if five years have passed since the first year of contribution, and you have reached 59½, died, become disabled, or make a first-time home purchase. If a Roth IRA distribution is not qualified, the earnings portion of the distribution is taxable (and may be subject to a 10% penalty if you are not yet 59½).