If the complexity of the Roth vs. traditional IRA decision is preventing you from opening an account, just know this: There are no bad choices here. Each rewards you with tax breaks for saving for the future and offers easy access to the types of investments that will help your nest egg grow.
But there are rules — rules about who’s allowed to use which type, rules about contribution amounts, withdrawal rules, and taxes, taxes, taxes. The combination of tax law and investing makes the Roth vs. traditional debate inherently confusing.
Don’t let IRA analysis paralysis keep you on the retirement savings sidelines. Simply choosing one and getting started is a win.
This HerMoney Guide to Roth and traditional IRAs deconstructs the most important rules to help you decide which type of IRA — or combination of both! — is best for you.
What these IRAs have in common
Setting aside differences for the moment, here are the ways Roth and traditional IRAs are the same:
- Contribution limits: For 2022 you’re allowed to contribute up to $6,000 (or $7,000 if you’re age 50 and older) to either type of IRA. In 2023, those numbers will increase to $6,500 and $7,500 to either type of IRA. Can’t decide? You can save money in both types in the same year (e.g. $3,000 in a Roth and $3,000 in a traditional), as long as your total IRA contributions don’t exceed the IRS’s annual limits.
- Contribution deadline: You have until the day your taxes are due (July 15 for the 2019 tax year) to set up and fund your Roth and/or traditional IRA for the previous year. But you don’t have to do it in one lump sum. You can gradually work up to it by depositing money into your IRA each month. To max it out in 12 months you’d need to save $500 a month if you’re under 50, or $375 each month if you want the extra time right up until tax day to scrounge up the cash.
- Investment choices: Roth and traditional IRAs are not themselves investments: They are empty accounts (with magical tax-deflecting properties) to hold your money. You — or your financial pro — choose how to invest the money in the account. Both types of IRAs are set up to handle everything from individual stocks, mutual funds, ETFs, bonds, Certificates of Deposit and cash.
- How investments are taxed along the way: As long as your money remains in an IRA, you won’t owe taxes on any investment growth (e.g. earnings or dividends). That’s one of the tax protections that makes both Roth and traditional IRAs a smart place for your long-term savings. In a regular investment account the IRS taxes investment gains every year.
- Penalty-free withdrawals: Age 59 ½ is the magic half-year birthday when the IRS allows you to start withdrawing money from both Roth and traditional IRAs. Before then, withdrawals may be subject to income taxes and a 10% early withdrawal penalty. However, there are situations with both types of IRAs (discussed below) where you can avoid the penalties if you tap into your account before it’s fully cooked.
- No minimum funding requirement: The IRS caps how much you can save in an IRA each year. But there’s no obligation to contribute the full amount to open one. Each financial institution sets its own required minimums. In fact, many allow you to start funding an account with whatever change is jangling around at the bottom of your purse.
The main difference: How and when you’re taxed
The biggest difference between the traditional and Roth IRAs is the tax break: A traditional IRA offers a tax deduction on contributions (the Roth doesn’t). A Roth offers tax-free withdrawals (whereas withdrawals from a regular IRA are taxed as income).
You could make a decision about which IRA is best for you based on that single piece of information. For example: If you know you’ll be in a higher tax bracket in retirement than you are now, the Roth’s tax-free withdrawals are more valuable to you. If you’re in a high tax bracket right now or predict your tax rate will be lower in retirement, a traditional IRA is a good choice.
For those of us without a reliable Tarot reading of our future tax bracket, the decision requires knowing what other ways these IRAs differ from each other.
Roth and traditional IRAs aren’t the only game in town. Here are 6 IRAs Every Woman Needs to Know About
The IRS is the bouncer at the front door of the IRA contribution club. How much you’re allowed to shield from taxes and when you get that tax break is based on your tax situation — your tax filing status, income and other factors. (Answer a few questions and this Fidelity IRA calculator will tell you which type of IRA is in the running for you.)
Traditional IRA contribution rules:
Anyone with earned income is allowed to contribute to a traditional IRA. The question is: How much of that contribution is deductible. (Remember: traditional IRA contributions reduce your taxable income on a dollar-for-dollar basis up to a maximum of $6,000 in 2022 and $6,500 in 2023 ($7,000 and then $7,500 if you’re 50 or older).)
How much you’re eligible to deduct from this year’s taxes is based on three things: Your tax filing status (if you file as single or head of household, married filing jointly or married filing separately), your modified adjusted gross income (MAGI), and whether you or your spouse is covered by a retirement plan at work.
Traditional IRA Contribution Rules
Roth IRA contribution rules:
There’s no question about how much of your Roth IRA contribution you’re allowed to deduct from your taxes — because there is no upfront tax deduction. The tradeoff is that your withdrawals down the road are tax-free.
The Roth eligibility question is more straightforward: Am I even allowed to contribute, and if so, how much? Unlike with a traditional IRA, it doesn’t matter whether or not you (or your spouse, if you’re married) is covered by a workplace retirement plan. The answer is based solely on your income. Or, more specifically, your modified adjusted gross income (MAGI).
At some point on the MAGI sliding scale the amount you’re allowed to contribute starts phasing out. (PS: If you’re barred completely from saving in a Roth, there’s a workaround that involves converting a traditional IRA into a Roth IRA — aka “the backdoor Roth.”)
The differences between the Roth and standard IRA are on full display when it’s time to flip the switch from saving to spending mode. The IRS treats withdrawals (aka distributions) in retirement very differently, depending on which account you dip into. Uncle Sam also has distinct rules for early withdrawals. Spoiler alert: If you think you’ll need to tap your retirement savings early (as in before age 59 ½), a Roth IRA is the friendlier choice.
Traditional IRA withdrawal rules
You can only dodge paying taxes for so long with a traditional IRA. When you start taking distributions, your withdrawals — of both earnings and those tax-deferred contributions — are treated as income. The IRS will tax that money at your going income tax rate.
Another withdrawal rule that applies only to traditional IRAs: The IRS requires you to start taking yearly distributions (required minimum distributions, or RMDs) starting at age 72. And, yeah, there’s a penalty for failing to do that, too. Because IRS.
Uncle Sam gets really cranky if you crack open a traditional IRA before age 59 ½: In addition to income taxes you’ll owe a 10% early withdrawal penalty.
There are some exceptions to the early withdrawal rules. You’ll still pay income taxes, but you can avoid the 10% penalty if the money you take out early is used for qualified higher education expenses (for yourself or an immediate family member), up to $10,000 for a first-time home purchase, certain medical expenses, if you’re a qualified reservist, if you become permanently disabled and, new in 2020, if you become a parent through birth or adoption.
Roth IRA withdrawal rules
Withdrawals from a Roth IRA after age 59 ½ are completely tax-free! That tax-free status applies to both contributions and your investment earnings.
The Roth IRA also has no rules that require you to start taking distributions at age 72. You can leave your money in the account indefinitely, which makes it a nice parking spot for money you want to pass along to your heirs.
On early withdrawals, the Roth IRA has one huge advantage over its traditional sibling: You can withdraw your contributions — not earnings (hands off those!) — for any reason and at any time. And you won’t have to pay taxes or an early withdrawal penalty. Don’t even side eye earnings, though: Unqualified withdrawals of earnings will be met with a tax bill and that 10% early withdrawal penalty.
Like the traditional IRA, there are exceptions to the “you touch, you pay out the nose” rules: You can avoid taxes and an early withdrawal penalty on earnings if your account has been open for five or more years and the money (up to $10,000) is used for a first-time home purchase, you’ve become disabled, or a beneficiary is withdrawing money after you’ve died.
The bottom line
In a world where women face so many obstacles to securing their financial futures, saving for retirement is a must, especially if you’re behind in saving for retirement. Tax-advantaged accounts like Roth and traditional IRAs will help ensure you get the most out of every dollar you tuck away.
Knowing the differences between the two types of IRAs — the upfront tax deduction you get with a traditional IRA or tax-free withdrawals offered by the Roth — will help you decide which one is best for your situation.
Don’t be put off by the details. Like we said at the top of this guide, both are great retirement savings options. Even if you resort to throwing a dart to decide, merely making that choice to sock away some money in an IRA — whatever you can afford to start — is a move that you won’t regret.
Roth vs. Traditional IRA Comparison
More on saving for retirement:
- 6 IRAs Every Woman Needs to Know About
- IRA vs. 401(k): What’s the Difference?
- The Difference Between a 401(k) and a 403(b)
- The Freelancer’s Guide to Saving for Retirement
JOIN THE CLUB: Own your money, own your life. Subscribe to HerMoney today for inspiration, advice, insights and more!