boy making choice deciding on best option

The 401(k) is an excellent tool for getting started with investing and saving for retirement — but is it enough to sustain you throughout your post-working years? If you’re unsure, you might consider adding an individual retirement account (IRA) to the mix. But what type of IRA is best?

You’ve got two options: a traditional IRA or Roth IRA.

Each has its individual benefits and drawbacks, and determining what type of IRA is best for you depends on your personal situation. The maximum annual contribution to either type of IRA is the smaller of your taxable income or $5,500 (plus $1,000 in catch-up contributions for those 50 and over), but that’s where the similarities end. Here are some of the differences you should know about:

Taxes and IRAs: pay now or pay later?

  • Pay later. Contributions to a traditional IRA may be tax-deductible in the current year, depending on your income and certain other factors (check out the IRS guidelines to determine if you qualify). This means that you defer paying taxes on your contributions instead of paying them in the current year. The traditional IRA also offers tax-deferred earnings, so you won’t pay taxes on either your contributions or their earnings until you make a withdrawal from your IRA.
  • Pay now. Roth IRAs offer the potential for tax-free earnings and, typically, tax-free withdrawals (see more on this below). Contributions are not deductible in the current year, however. Unlike a traditional IRA, you pay the taxes on your contributions up front.

Age limits on IRA contributions.

In order to contribute to a traditional IRA, you have to be younger than 70½ at the end of the tax year (Dec. 31). Roth IRA contributions can be made at any age. Similarly, you can make rollover contributions to either type of IRA regardless of your age.

Income limits.

If your income exceeds published limits, you may not be able to contribute to a Roth IRA, or you may only be eligible for reduced contributions. You can contribute to a traditional IRA regardless of your income — but whether those contributions are deductible depends on your income and other factors.

IRA withdrawals.

Withdrawals from a traditional IRA are taxable when distributed. How much you’ll pay in taxes depends on whether contributions were made with pre- or post-tax money. Distributions may also be subject to an additional 10% early distribution penalty if you’re under the age of 59½. Exceptions to this tax are available in cases of death, total and permanent disability, or certain qualified expenses such as education, medical, and first-time homebuying, among others.

With Roth IRAs, withdrawals and earnings are tax-free if it’s been at least five years since you first funded the account and one of the following conditions applies:

  • You’ve reached age 59½.
  • You’ve become disabled.
  • Your beneficiary is receiving the distribution due to your death.
  • You’re making a qualified first-time home purchase.

Comparing traditional and Roth IRAs.

Let’s look at traditional and Roth IRAs side by side:

Traditional IRA

Roth IRA

Who can make contributions? Wage-earners under age 70½ at end of calendar year. Wage-earners of any age with restrictions based on tax-filing status and annual modified adjusted gross income AGI.
Are contributions deductible? Yes, but with restrictions based on tax-filing status, annual modified AGI, and access to a workplace retirement plan. No.
Annual contribution limit $5,500 ($6,500 if 50 or older); limited to lesser of earned income or contribution limit. Same as traditional IRA.
Offers tax-free compounded income? No. Yes.
Taxes on withdrawals of contributions and earnings Withdrawals are taxed; tax liability based on deductibility of original contributions. Withdrawals of contributions aren’t taxed; earnings generally are taxed if taken before age 59½ and if they don’t meet the five-year holding period requirement.
Early withdrawal penalty 10% on most withdrawals before age 59½. Withdrawals of contributions are not penalized; 10% penalty on withdrawal of earnings 1.) before age 59½ or 2.) not meeting tax-year holding period requirements.
Required minimum distributions (RMDs) at age 70½ Yes. No; exceptions possible upon death of account owner.

Making your decision.

So how do you decide which type of IRA is better for you?

Choosing between a traditional or Roth IRA mostly hinges on your current and future tax rate. Remember, the main difference between the two types of IRAs is when you’ll pay the taxes — now or later. So, it’s to your advantage to pick a time when your tax rate is at its lowest! The challenge with this choice is that it’s hard to predict what your future tax rate will be.

  • A pre-tax savings strategy such as a traditional IRA tends to work for people currently in higher tax brackets because they may benefit from an immediate tax break due to the deduction. It can also be helpful for those who expect to be in a lower tax bracket when they retire.
  • After-tax accounts like the Roth IRA may be more attractive to people in the early part of their career, when earnings (and therefore tax rates) are generally at their lowest point. People who expect their tax rate will be higher in retirement may want to consider the Roth IRA.

For many investors, the deductibility of traditional IRA contributions steers them in that direction, while others are more attracted to the tax- and penalty-free distributions of the Roth IRA. Drawn to both? You’re not alone. Assuming you’re eligible to make contributions to both types of IRAs, a possible solution is splitting your annual contribution between a traditional and Roth IRA so you can enjoy the benefits of both. This type of “tax diversification” may give you the flexibility you’re looking for. But remember, you’ll still be limited to the maximum annual contribution of $5,500 (or $6,500 if you’re over the age of 50).

What’s next?

Like most aspects of personal finance, there isn’t a one-size-fits-all answer to whether or not you should choose a traditional IRA or a Roth IRA. Consider your unique situation and understand the tax implications of each option. Ideally, your choice of IRA should be part of a larger tax optimization plan for your retirement savings. You can start your analysis by visiting our Traditional vs. Roth IRA Calculator. Next, consider consulting an investment advisor who can look at the specifics of your situation, tax strategy, and overall financial plan to help you make an informed decision.

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