An Individual Retirement Account (IRA) is a tax-advantaged way to save for retirement. The two main types of IRA accounts for individual investors are Traditional IRAs and a Roth IRAs. While both account types offer extremely enticing tax treatments, the main difference between the two account types is the tax treatment of contributions compared to distributions. The key to choosing the account type that best fits your needs is to understand the tax treatment of the account types and if you qualify to make contributions or take deductions. 

Traditional IRAs were established in 1974 and contributions to a Traditional IRA are generally made with pre-tax dollars, grow tax-deferred, and distributions are fully taxable. 

Contributions- An investor would put money into a Traditional IRA and then reduce their taxable income by the contribution amount, therefore not paying taxes on the amount that was contributed to the account. 

There are no income limits to contribute to a Traditional IRA, but there are certain stipulations to be able to deduct your contributions. Investors that are actively participating in certain retirement plan sponsored by their employer, such as a 401(k) or 403(b) plan, may not be able to deduct contributions depending on your tax-filing status and income level.1 For example, a single person making $63,000 in 2020 and contributing to a 401(k) plan can deduct their full contribution to a Traditional IRA. However, if that same taxpayer made $76,000 in 2020 and continued to make contributions to a 401(k) and traditional IRA, they could not deduct the amount they put into a Traditional IRA.

Growth and Distributions- Growth on the investments within the traditional IRA are tax-deferred, meaning taxes are not paid until a distribution is made. When it comes time to tax distributions, taxes are owed at the investor’s ordinary income tax rate. If your original contribution was not deductible, Uncle Sam will not tax you twice on that money. You will have created a basis in the account, meaning each distribution will be partially a return of your original investment dollars (the basis which is not taxable) and partially earnings (the growth on the basis which is taxable).

Generally, distributions taken before age 59 ½ are subject to a 10% early withdrawal penalty. When an investor turns 72, they will have to take what is called Required Minimum Distributions (RMDs). RMDs are calculated based on the size of the account and life expectancy. 

Roth IRA’s were established by the Taxpayer Relief Act of 1974. The main advantage to the Roth IRA is that contributions are made with after-tax dollars and distributions are generally made tax-free. 

Contributions- Investors put money into a Roth IRA and do not deduct the contribution from income so the money is fully taxable in the year it is earned. However, not everyone can put money into a Roth IRA. Investors who have income over a certain amount cannot directly contribute to a Roth IRA, depending on your tax filing status.2

Growth and Distributions- Investors can take out their Roth IRA contributions (or the “basis”) at any time, for any reason, tax and penalty free. Distributions of the growth may be subject to a 10% early withdrawal penalty and/or income taxes. 

Qualified distributions are income-tax free and not subject to a 10% early withdrawal penalty. A distribution is “qualified” when it is made five years after the first contribution AND after the investor turns 59 ½, upon the owner’s death or disability, or for a first-time home purchase (up to $10,000). 

You may have also heard that you can use a Roth IRA to pay for higher education. Distributions for qualified education expenses are not subject to the 10% penalty, but you would still owe income taxes on the growth portion of your withdrawal. 

Unlike a Traditional IRA’s RMD, investors do not have to take distributions anytime during their lives from a Roth IRA.

Check out Lydia Gosselin’s blog post titled The Power of the Roth to learn about some powerful tax strategies, like a Two-Step Roth Conversion. 

Both Roth IRAs and Traditional IRAs have combined contribution limits of the lesser of your earned income or $6,000 for 2020. Investors over 50 years old qualify for a catch-up provision that allows an additional contribution of $1,000. The limit is based on the taxpayer, not on the account.

For example, let’s say a married couple with a combined income of $150,000 in 2020 would like to make the maximum contributions to Roth IRAs. Each spouse can contribute $7,000 ($6,000 limit plus a $1,000 catch-up) to a Roth account. If each spouse has multiple Roth IRA accounts, the combined total contributions cannot be more than $7,000 per spouse. Either spouse could also split their contribution between a Traditional IRA and a Roth IRA, although that is fairly uncommon.

Keep in mind that IRAs and most retirement plans sponsored by employers have different contribution limits and you can contribute to both an IRA account and your retirement plan through work. Contributing to an IRA does not affect your ability to make contributions to a retirement plan through work and vice-versa, however, as discussed previously, it may affect your ability to deduct a contribution to a Traditional IRA.

If you have not filed your 2019 tax returns, there’s still time to make a 2019 IRA contribution! Contributions must be made before you file your tax returns or by April 15th (or the due date of your tax return without extensions).

Ultimately, the decision comes down to eligibility and forecasted tax treatment. We obviously cannot be sure of what tax rates will look like in the future, but with the U.S. debt constantly reaching all-time highs and tax rates currently at all-time lows, we can certainly anticipate that the ever-present tax burden on individual investors has to increase at some point which can make the Roth option appealing today. Either way, both Traditional and Roth IRAs are fantastic tax-advantaged ways to help you build your nest-egg.

1Traditional IRA Deduction Limitations if you Contribute to a Qualified Retirement Plan at Work