An IRA is a fantastic tax advantage retirement saving and investing tool. When you open an IRA (Individual Retirement Account), you will face two choices: Roth IRA or Traditional IRA.
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We come from different walks of life and are in different financial situations. It’s essential to know the differences between both Roth IRAs and Traditional IRAs before choosing one (or both)!
My wife and I chose the Roth IRA because we don’t want to worry about tax when we retire. The thought of being a tax-free millionaire in the future is exciting.
After we paid off our student loan debt, we started maxing out our two Roth IRAs, which total $12,000 a year.
The deadline to max out an IRA each year is typically the same as the filing tax return deadline – April 15.
For example, you can still contribute to your 2021 IRA up until April 15, 2022.
Both the Roth and Traditional IRAs provide generous tax breaks. But which one should you choose?
In this article, I will discuss the 5 key differences between Roth and Traditional IRAs. We hope this information can help you make a more informed choice. 🙂
The 5 Key Differences between Roth and Traditional:
- Tax Benefits
- Limited Income
- Withdrawals
- Early-withdrawal penalties
- Distribution Rules (RMDs)
Table of Contents
1. Tax Benefits
Both Roth and Traditional IRAs provide generous tax breaks. If you expect to be in a higher tax bracket when you retire or retire without needing to worry about tax, the Roth IRA will probably be better suited for you.
But if you expect to be in the same or lower tax bracket when you retire, then Traditional IRA probably will be a better suit for you. Why? See below:
- Roth IRA: You can make an after-tax contribution and the money will grow tax-free.
- Traditional IRA: You can make pre-tax contributions if you meet income eligibility (check below for point 2 – limited income). Your contribution growth will be tax-deferred.
2. Limited Income
The 2020 and 2021 contributions limit for Roth and traditional IRAs is $6,000 or $7,000 if you’re age 50 and older. You must have enough earned income to cover the contribution.
For Example: If you only made $1000 in 2020, you can only contribute up to $1000 to your IRA in 2020.
- Roth IRA: In 2022, the annual income limit is $144,000 for single and $214,000 for married filing jointly. This means if you are above that income, you will not be able to contribute to the IRA.
For more details see the Amount of Roth IRA Contributions That You Can Make for 2022 | Internal Revenue Service (irs.gov)
- Traditional IRA: There are specific income (AGI, adjusted gross income) limits that impact much you can contribute in pre-tax dollars. This is divided into two situations: you have a retirement plan at work, or you DON’T have a retirement plan at work.
If you are covered by a retirement plan at work, please check: 2021 IRA Deduction Limits – Effect of Modified AGI on Deduction if You Are Covered by a Retirement Plan at Work
If you are NOT covered by a retirement plan at work, please check: 2021 IRA Deduction Limits – Effect of Modified AGI on Deduction if You Are NOT Covered by a Retirement Plan at Work
3. Withdrawals
- Roth IRA: Earnings from a Roth IRA can be withdrawn tax-free and penalty-free when you are 59½, and the Roth IRA must have been open for at least five years. However, withdrawals of your contributions can be taken out at any time without a penalty.
- Traditional IRA: Earning withdrawals can happen penalty-free after age 59½ but will be taxed at your income tax rate. Contribution withdrawals after 59½ are also subject to tax unless you’ve made nondeductible contributions; in that case, only part of your withdrawal will be tax-free.
4. Early-withdrawal penalty
For both Roth and Traditional IRAs, If you withdraw money before age 59½, you might have to pay taxes on your earnings, plus a 10% early withdrawal penalty.
4. Distribution Rules (RMDs)
- Roth IRA: You are not required to withdraw any minimum money at any age.
- Traditional IRA: Generally, you will be required to make a taxable withdrawal for a minimum amount of money at age 72.
Traditions Vs. Roth IRA: Conclusion
The Roth IRA and Traditional IRA are excellent tax advantage retirement accounts and will help in pursuing financial freedom.
Different people have different fiance situations. Make sure to understand the differences between Roth IRA and Traditional IRA before you make your own decision.
My wife holds her IRA at Vanguard and mine is with Fidelity. Both investment companies have been great to work with!
The most important thing is to start investing early and start now.
M1 Finance is a great investment opportunity with its robust yet simple app. There are ZERO commissions or account management fees.
Deposits $1,000 or more into your M1 Invest account within two weeks of signing up and get a cash bonus of $30-$500 to that account.
It is not just a trading stock brokerage account but also offers an IRA option that allows you to invest in your retirement.
We highly recommend using M1 Finance to open a brokerage or retirement account! M1 Finance can undoubtedly help you on your financial independence journey.
Compound interest is the most beautiful thing in the world. You will see how miraculous it is and how it grows like crazy over time!
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
Albert Einstein
We’d love to hear which type of IRA you are interested in or using! Drop a comment in the box below. 🙂
Disclaimer:
We hope the information in this article provides valuable insights to every reader but we, the Biesingers, are not financial advisors. When making your personal finance decisions, research multiple sources and/or receive advice from a licensed professional. As always, we wish you the best in your pursuit of financial independence!
