I field this question a few times a month and I always start my answer with this question – When do you want to pay the taxes?
The main difference between a Traditional IRA and a Roth IRA is when you pay taxes on the contributions and earnings. With a traditional, you defer paying taxes on contributions and earnings until you take withdrawals. If you have a Roth, you pay taxes on the contributions before they go into the account, but your withdrawals are tax-free, including any earnings.
If you think that you’ll be in a lower tax bracket when you start taking withdrawals from your account, then you should use a Traditional IRA when making contributions. For younger savers just starting out in the workforce, I usually recommend using a Roth since their income is typically low which puts them in a very low tax bracket. Once their income starts to ramp up, they may save more on taxes by switching to a Traditional.
Here is a nice summary of the features of each type of IRA:
| Feature | Traditional IRA | Roth IRA |
| Tax benefits | Tax-deductible contributions and tax-deferred growth | Tax-free growth potential and qualified withdrawals are tax-free |
| Age requirements | Prior to 2020, individuals over 70½ could not make contributions. Under the SECURE Act of 2019, contributions are allowed at any age. | Contributions are allowed at any age. |
| Income requirements | Anyone over 18 with any amount of earned income can contribute. However, income limits may decrease or eliminate the amount that is tax-deductible. | A single taxpayer with a modified adjusted gross income of $139,000 or more is not allowed to contribute. The limit is $206,000 for married taxpayers who file jointly. Single taxpayers earning between $124,000 and $139,000 can make only partial contributions. The same is true for married taxpayers who file jointly earning between $196,000 and $206,000. |
| Contribution limits | For 2020, the total contribution limit for all IRAs is $6,000, or $7,000 for individuals 50 and older. | The same IRA contribution limits apply. You cannot contribute more than your taxable compensation for the year. |
| Taxes upon withdrawal | Withdrawals are taxed for pre-tax contributions and earnings. | Earnings can be withdrawn tax-free as long as you are over 59½ years old. Your contributions can be withdrawn any time without penalties or taxes. |
| Early withdrawal penalties | If you withdraw funds before age 59½, you may be subject to tax on your contributions and earnings plus a 10% additional tax. | Withdrawals before age 59½ may incur a 10% tax penalty in addition to taxes on your earnings. |
| Required minimum distributions | A required minimum distribution (RMD) must be taken during the year you turn 72. | There are no required distributions during your lifetime. |
In summary, you’re going to get taxed either way, but if you plan accordingly, you can use both of these IRA options to maximize your retirement savings.
Please let me know if you have any questions.
Joe Baker, CFP®
Baker Asset Management, LLC
joebaker@bakerassetmanagement.com
