Americans believe they'll need $1.46 million to retire comfortably, according to findings from Northwestern Mutual’s 2024 Planning & Progress Study, and an individual retirement account (IRA) is a great tool for building a robust nest egg. The question, then, is not if you should have an IRA, but which kind you should use.
If you make ongoing contributions and diversify your investments, you could build a portfolio that’s worth hundreds of thousands dollars. But there are actually two flavors of IRAs: a traditional IRA and a Roth IRA.
Which account represents a better option for your retirement? This is not an easy call. Even experienced financial planners can struggle with this question. But there are some key factors to consider and they are generally about the tax implications.
To better understand all this, it’s first important to evaluate the common features and differences for traditional IRAs or Roth IRAs.
The similarities between Roth and traditional IRAs
For 2024, the contribution limit is $7,000 for both traditional and Roth IRAs. If you are 50 or older, you can add an extra $1,000, for a total 2024 contribution limit of $8,000.
For any given tax year, you generally have until the tax deadline the following year to make a contribution. So, for the 2024 tax year, most people have up until Tax Day 2024 to contribute to their IRAs. There are no age limitations.
The contribution amount must come from your earned income like wages, salary, commissions, tips, bonuses or profits from self-employment. This does not include earnings from rental income, annuities, pensions or deferred compensation.
If a spouse does not work, the other spouse’s earned income can qualify in order for them to open a separate IRA in their own name, which is known as a “spousal IRA.” The other spouse's earned income can be used so long as the couple files a joint federal return.
Now let’s take a look at some of the main differences. They include whether you can deduct a contribution and if distributions are tax-free.
Tax deduction for Roth vs traditional IRAs
The IRS prohibits taxpayers from taking a deduction for Roth IRA contributions. But contributions to a traditional IRA may be deductible.
Suppose you file as single and are age 55. You have been falling short of your retirement goals, so you decide to make a maximum contribution to your IRA account. This includes $7,000 plus the $1,000 catch-up contribution for a total of $8,000. Based on your current income, you are in the 24% federal tax bracket. This means your deduction will be 24% multiplied by $8,000, or $1,920. You may also be eligible for a state tax deduction.
But there is a wrinkle. You may not be able to take the full deduction for your traditional IRA contribution if you or your spouse is eligible for an employer-sponsored retirement plan like a 401(k) or 403(b). The amount of the contribution will be phased out based on your modified adjusted gross income (MAGI). Each year, the IRS sets the limits.
Tax-free distributions
For traditional IRAs, the IRS imposes restrictions on the distribution of funds from your account. If you make a withdrawal before reaching 59-½, you will be subject to income taxes and a 10% penalty. There are some exceptions to the penalty, such as for total and permanent disability, $10,000 for a qualified first-time home purchase and some unreimbursed medical expenses.
The penalty also does not apply when you reach 59-½. However, you are still subject to income taxes.
For a Roth IRA, there are fewer restrictions on withdrawals. At any time, you can take out your contributions tax-free and without a penalty. But when it comes to earnings in the account, you need to be 59-½ and have held the Roth IRA for at least five years for this to apply.
Let’s illustrate this with an example: You are single, age 58 and in the 24% tax bracket. You set up a Roth IRA two years ago and have contributed a total of $20,000, and the earnings on the account are $5,000. You can withdraw the $20,000 without having to pay taxes or a penalty. But this is not the case for your earnings. You will pay $1,200 in taxes, or 24% multiplied by $5,000, and a $500 penalty, which is 10% multiplied by $5,000.
Should you use a Roth or traditional IRA?
Evaluating whether to select a traditional IRA or Roth IRA comes down to thinking about different scenarios. For example, if you are currently in your peak earning years and believe your income will be lower in retirement, then you may want to select a traditional IRA. The reason is that your distributions will be taxed at a lower rate.
On the other hand, if you are young and just starting a career, then a Roth could be a better option. The tax savings from the deductions of the traditional IRA might not be as attractive.
Estate planning is another important consideration. Unlike a traditional IRA, you will not have to make required minimum distributions (RMDs) for your Roth IRA when you are alive. You also can bequeath the account to your heirs, however, they will be subject to withdrawal requirements. Your heirs, except your spouse, must either take out all the funds or set up an inherited Roth IRA, which includes RMDs. If the account was inherited after 2019, these distributions generally are for a 10-year period. As long as the Roth IRA has been in existence for five years, the amounts are tax-free.
Another benefit of a Roth IRA is that it can force you to set aside more money for your retirement. How so? With a traditional IRA, it’s common for people to spend their tax savings soon. For example, a survey from Primerica found that 37% of the respondents will use their refunds this year to pay bills and 34% to reduce their debts. About 33% said they would add to their savings and only 1% would invest the money in their retirement account. But with a Roth IRA, the tax savings are not available until later, when you make withdrawals, so you automatically have that money later rather than sooner.
The decision as for what account to invest in is certainly complicated. After all, the evaluation is about forecasting the future – and this usually needs to be done for many years. This is why you might want to split your contributions to both a traditional and Roth IRA.
But for this strategy to work, you need to be eligible for the Roth IRA. For 2024, you can contribute the maximum limit if you are single and your modified adjusted gross income (MAGI) is less than $146,000. This is gradually phased out until this amount reaches $161,000. The limits for married taxpayers filing jointly are from $230,000 to $240,000 respectively.
However, if you qualify, you can get the benefits of both a traditional and Roth IRA. Then as your circumstances change over time, you can make adjustments to how you make your allocations. It is possible to convert a traditional IRA to a Roth IRA.
