Understanding the Difference Between Traditional and Roth IRAs

The most significant difference between Traditional IRAs and Roth IRAs is that when you contribute to a Traditional IRA, you contribute pre-tax dollars and when you contribute to a Roth IRA, you’ll make your contributions in after-tax dollars. Inversely, when you pull money from your Traditional IRA, you’ll pay taxes based on your tax bracket, whereas the money you pull from your Roth IRA will be tax-free, providing you meet eligibility requirements.

What’s the implication? With a Traditional IRA, you’ll have to allocate less income toward saving for retirement, because you’ll be investing money before paying taxes, whereas with a Roth IRA you’ll have to use more of your income to initially invest the same amount. You can also use a Traditional IRA as a tool to help lower your current tax rate if you’re already making a substantial salary.

Alternatively, a Roth IRA will give you the benefit of paying no taxes on all the compounded money accumulated before taking distributions and you’ll have more flexibility on the timing of your withdrawals.

The Differences Between IRAs and Roth IRAs At A Glance

Although there are specific qualifications and limitations with either IRA, this high-level chart will provide an easy way to compare the basic differences between the two. 

For more detailed information, review the detailed version of this chart on the IRS website.   

So how do you know which IRA is right for you?

That’s when it gets a little more complicated, but essentially it boils down to taxes and whether it’s smarter to pay them now or later. It’s important to always consult your tax professional when making a determination about which is right for you. 

The Case for the Roth IRA

Let’s say you’ve saved well and accumulated a lot in your retirement funds. It’s possible that a combination of your Required Minimum Distributions (RMDs) from accounts like 401(k)s and Traditional IRAs, not to mention income from property, social security and other investments, can put you in a higher tax bracket. That’s when pulling tax-free from a Roth IRA can help keep you in a lower tax bracket during retirement. Or, because RMDs aren’t required with a Roth, you can forego the withdrawals entirely and just live off other income streams.

The Case for the Traditional IRA

On the other hand, if you make a salary that puts you in a high tax bracket currently, and you plan to be in a much lower tax bracket when you retire, even with your RMDs, then a Traditional IRA might be the better choice — not to mention that if you’re above a certain salary currently, a Roth IRA may not even be an option.

There’s also the possibility that Congress could always change the tax laws — no longer providing tax-exempt status for Roth IRAs. And to gain the tax advantage of a Roth IRA, you have to have it for at least five years before taking distributions and be at least 59.5 years old. 

You can also split the difference and put half of the maximum contribution in a Roth and half in a traditional IRA.

Take the First Step

 

The tricky part is trying to predict what tax situation you might be in when you retire. Talk to your CPA as part of your annual tax preparation. They can answer more complicated questions when it comes to the inner workings of each IRA. And by pairing your CPA with your Avantax Planning Partners financial planning consultant together, you can map out a long-term strategy for your financial future — including which type of retirement account might best suit your needs.