The Similarities and Differences Between a Traditional and Roth IRA
If you’re working on retirement planning, you’re likely considering opening an IRA. Traditional vs. Roth IRA? Which one do you pick? Let’s take a look at their similarities and differences, to make sure you select the one that makes the most sense for you.
Common Elements of Both
Both types of IRAs have a number of basic elements in common. A traditional and Roth IRA allow you to take advantage of many different investment options. The different investment options that can be utilized in a traditional or Roth IRA include:
- Mutual funds
- Exchange-traded funds
- Money Market Funds
- Certificates of Deposit
- Annuities (but you may not want to since an annuity already provides tax-deferred growth)
Another similarity between the two different types of IRAs is the contribution limits available for both. Each of these IRAs allows for the same level of contribution each year. In 2019, you are able to contribute up to $6,000 to a traditional IRA or a Roth IRA. Also, if you’re 50 or older you’re able to make an additional contribution of $1,000. Otherwise known as a catch-up contribution. This catch-up contribution is available if you don’t have a fully funded IRA by the time you reach the age of 50.
Both IRA’s also allow for tax-deferred growth within the account. Meaning, as your investments grow over time, you won’t pay income or capital gains taxes until you begin withdrawals in retirement.
A significant difference between a traditional IRA and a Roth IRA is the type of dollars that are used for contributions. Contributions into a traditional IRA are made with pre-tax dollars. This is a tax advantage because you’ll have a lower Adjusted Gross Income (AGI) and therefore pay less in income tax. Now, during retirement, when you start to take distributions, you’ll pay income taxes on the gain.
Conversely, a Roth IRA is funded with after-tax dollars. Unlike a traditional IRA, you don’t get to lower your AGI when you contribute to a Roth IRA. The benefit is on the back-end. When you begin to take distributions in retirement, you won’t pay any income tax on the gain in the account, unlike a traditional IRA.
There are certain directives associated with using Roth IRA contributions without tax consequences. First, a contribution cannot be made until five years after the first contribution was made into a Roth IRA.
Second, one or more of these factors must be present in order to take a distribution from a Roth IRA:
- Reaching the age of 59 1/2
- You become disabled
- You die and a beneficiary receives a distribution
- Money from the Roth IRA is used to purchase of a first home, up to $10,000 from the IRA
Age Limits of Both
Age limits represent another difference between a traditional IRA and a Roth IRA. You can make contributions into a traditional IRA up until you reach the age of 70 1/2. There is no age cap when it comes to making contributions into a Roth IRA. You can make contributions into Roth for as long as you desire.
Penalties for a Traditional IRA and a Roth IRA
There’s a difference between a traditional IRA and a Roth IRA when it comes to penalty issues for early withdrawal. A penalty is imposed for early withdrawal from a traditional IRA. There is no penalty involved with early withdrawals of your contributions from a Roth IRA. That’s because a traditional IRA is funded with pre-tax dollars and a Roth IRA is funded with after-tax dollars.
Before you take money out of a traditional IRA, examine closely both the tax and penalty consequences. An early withdrawal can wreck an IRA if you’re not careful. Unless you have a true emergency, you should avoid an early withdrawal from your traditional IRA. Also, keep in mind that an early withdrawal from either type of IRA results in less money available to you when you retire.
Now that you know more about both IRA’s, you can make a more educated decision regarding which IRA is best for you.