Traditional vs. Roth IRAs: What’s the difference?

As you explore your options for retirement investing, the terms “traditional IRA” and “Roth IRA” are sure to come up. While they’re very similar investment accounts, there are some important differences between them — and those differences can be a big deal when it comes to your retirement funds.

Let’s first explore the similarities of these IRAs (short for individual retirement accounts), then dive into the differences to help make sense of how either account can affect your retirement money — especially when it comes to how and when you pay taxes.

Ready to talk IRAs? Let’s get right to it.

What’s similar about them?

There are numerous commonalities between traditional and Roth IRAs. Here are the biggies:

• Investments such as stocks, bonds, mutual funds, and ETFs (exchange-traded funds) are typically available in both. Your money will be invested according to your individual investment allocation, and most accounts have several options you can divide your savings among to diversify your portfolio.
• Yearly contribution limits are $6,500 (for 2023), with a $1,000 catch-up contribution for individuals 50 years of age and older.
• Individuals must have earned income to contribute to both accounts, and you can’t contribute more than your earned income in any given year.
• Penalty-free distributions are allowed starting at age 59-1/2. For penalty-free distributions from a Roth, the account must have been open for at least five years by the time age 59-1/2 is attained. In addition, you can distribute your contribution amount at any time, tax- and penalty-free. There are some exceptions to early withdrawal penalties in a traditional IRA — such as qualified education expenses, first-time home purchases, and more.
• Your money can grow tax-deferred in both accounts.

The differences make the difference

Traditional and Roth IRAs, despite their similarities, are quite different when it comes to their tax treatment — specifically in regard to when you pay the taxes on the money put into the account. Suffice it to say the IRS will want you to pay income taxes on the money, but you get to decide whether you pay those taxes before they are deposited into the account or when they’re distributed from the account.

In a Roth account, your contributions are made with post-tax monies. For this reason, you’re not able to deduct the contributions from your taxes, meaning you’ll have paid the taxes on the contributions before they go into the account. When you take distributions from the account — and you can do so whenever you choose — they’re tax-free.

In a traditional IRA, the funds are contributed pre-tax, which makes them tax-deductible and lowers your taxable income. For instance, if you make $50,000 and contribute $5,000 of that to a traditional IRA, your taxable income is lowered to $45,000 when you file your taxes. When you take distributions, however, the money will be taxed at that time at the current tax rate and according to your current tax bracket. The IRS has mandatory withdrawals on traditional IRAs the year a participant turns 73.

When do you want to pay the taxes?

Choosing between traditional and Roth IRAs comes down to when you want to pay the taxes on the funds in the account. For example, if you think you’ll be in a lower tax bracket once you retire because you’ll no longer be working and earning a regular income, you might consider investing in a traditional IRA.

In general, Roth contributions are better than traditional IRA contributions for the younger investor who is typically in a lower tax bracket and won’t benefit as much from the tax benefits of a traditional IRA. This is especially true if income tax rates increase in the future.

Generally, it’s good to have a mix of traditional and Roth IRA contributions. Taxes can be confusing and there is a lot that’s unknown about future taxes. If you have questions about which account might be right for your unique financial situation, our team is here to answer them. Give us a call or send us an email and we’ll be happy to help.