Traditional IRA vs. Roth IRA

IRAs in a nutshell

Individual retirement accounts (IRAs) were originally designed to provide individuals not covered by a workplace retirement plan with an option to save for retirement on a tax-advantaged basis.

• IRAs were first created as part of the Employee Retirement Income Security Act (ERISA) in 1974.
• IRAs were designed to help individuals shift money from an employer retirement account to another type of tax-advantaged account when changing jobs or leaving an employer.

Two types of IRA: traditional and Roth

IRAs now have two main types, the traditional IRA and the Roth. There are similarities between traditional and Roth IRAs, but also some distinct differences.

Both IRA accounts have the same overall annual contribution limits. In 2024, the annual limit is $7,000. People 50 and over can take advantage of an additional $1,000 catch-up contribution. The annual contribution limits apply to all IRA accounts combined. As we will discuss, there are certain limits that apply to both types of IRAs.

What is a traditional IRA?

A traditional IRA allows you to make contributions on a pre-tax basis, though both pre-tax and after-tax contributions are allowed. Contributions grow tax-deferred in the account until withdrawn, but most distributions are taxable (with the exception of the value of any after-tax contributions).

This means you don’t pay tax on the money you pay into your IRA. Instead, you pay tax when you withdraw the money. This can significantly reduce the amount of tax you pay, because it’s likely you’ll be in a lower tax bracket during retirement than when you are working.

What is a Roth IRA?

A Roth IRA is funded solely by after-tax contributions. The money in the account grows tax-free and is then withdrawn tax-free if the account holder meets certain requirements. With a Roth IRA, you pay tax at the time you earn. However, withdrawals from your account are then tax-free.

Traditional IRA pros and cons

Traditional IRA pros

• Upfront tax benefit in the year contributions are made.
• Money grows tax-deferred until withdrawn.
• Can easily move funds into account from a 401(k) when leaving an employer.

Traditional IRA cons

• Subject to required minimum distributions from the account.
• You will be taxed on the money withdrawn in retirement.
• Inherited traditional IRAs are taxable for a 10-year period for beneficiaries designated as non-eligible beneficiaries. This includes most non-spousal beneficiaries.

If you’re covered by a workplace retirement plan such as a 401(k), income limits govern whether or not you can make pre-tax contributions for that year. Note that after-tax contributions are always permitted, at least to the extent that you have earned income for the year. Here are those income limits for 2024:

Roth IRA pros and cons

Roth IRA pros

• Money grows tax-free and can be withdrawn tax-free as long as certain requirements are met.
• Tax diversification when paired with a traditional IRA or other post-tax retirement account.
• Can withdraw contributions tax- and penalty-free at any time.
• No required minimum distributions.

Roth IRA cons

• No current-year tax benefit for contributions.
• Contribution limits are based on your income.

For 2024 the income limits on a Roth IRA are as follows:

IRA contribution limits and your income

Both traditional and Roth IRAs have contribution limits based on your income. Limits for Roth IRAs are higher, but if you earn more than $161,000 a year (or $240,000 as a married couple), you can’t make tax-free contributions to these accounts.

There are several ways around this. First, note that if your Roth IRA contribution is reduced you can still contribute to a traditional IRA up to the overall contribution limit for the year.

If you are looking to contribute to a Roth account and your earnings are too high there are other options. If your employer offers a Roth option in their 401(k), 403(b) or other type of plan you can contribute after-tax money to that plan. There are no earnings restrictions, and the contribution limits are higher than with a Roth IRA.

Alternatively, you could do a Roth IRA conversion, including a backdoor Roth. Under these scenarios you would take money in a traditional IRA and convert some or all of those funds to a Roth IRA. Some or all of the conversion might be taxable.

Some employers offer a “mega backdoor” Roth that allows you to make relatively high after-tax contributions to a 401(k) plan that can later be converted to a Roth account.

Traditional IRA vs. Roth IRA

Both traditional and Roth IRAs are solid retirement accounts to consider. Which one is best for you will depend on your individual situation. Subject to any restrictions, you can use both types of IRAs depending on your needs.

Which IRA should you choose?

Both types of IRAs can be beneficial, and are often used together. In making the choice between a Roth and a traditional IRA, you should look at your own personal situation and your financial goals.

A traditional IRA might be the better choice if:

• Your income does not allow for Roth IRA contributions.
• You are looking for a current-year tax break on your contributions.
• You anticipate being in a lower tax bracket in retirement.
• You need to roll over assets from a traditional workplace retirement account such as a 401(k).

A Roth IRA might be the better choice if you:

• Anticipate being in a relatively high tax bracket in retirement.
• Need a source account to roll over assets from a Roth workplace retirement account such as a 401(k).
• Want to minimize taxable income in retirement to minimize taxes on Social Security benefits and any income-related surcharges on Medicare premiums.
• Want to diversify your retirement savings between traditional and Roth accounts.
• Want to avoid required minimum distributions.
• Anticipate passing on your IRA to non-spousal beneficiaries.

The bottom line: Traditional and Roth IRAs offer two ways to tax-advantaged retirement savings

Traditional and Roth IRAs aren’t mutually exclusive — in fact, they may be mutually beneficial. Though the annual contribution for any number of accounts is the same, the tax advantages now versus the tax advantages later can be part of your strategy to maximize your retirement savings.