Traditional vs. Roth IRAs

An Individual Retirement Account (IRA) is available to almost anyone who wishes to contribute a portion of his or her earnings to a long-term retirement investment account.

 

While there are similar benefits to both traditional and Roth IRAs, there are key differences that participants should be mindful of when selecting a plan.

Some limitations may apply to your contributions if you are also enrolled in a 401(k) plan at work. These limitations apply to both traditional IRAs and Roth IRAs. Neither a Roth account nor traditional account can invest in life insurance or collectibles, such as antiques.

Contributions

Traditional IRAs and Roth IRAs adhere to the same contribution limits. An individual cannot contribute more than $5,500 per year to his or her fund, or more than his or her total taxable income, depending on whichever amount is lower. These limits are upheld by the Employee Retirement Income Security Act (ERISA) and if exceeded, penalties will be applied.

Similarly, catch-up contributions later in life for both types of IRAs are set at $1000 after the age of 50. These contributions are additional to the base annual limit of $5,500. Therefore, if you are 50 years of age and older and have contributed the maximum amount of $5,500 for that year, you can contribute an additional $1000.

Taxes

If you are trying to decide which IRA to enroll in, you should consider one main factor: your future tax situation. This is perhaps where the biggest difference lies.

Contributions made into a traditional IRA are invested before federal and state taxes are taken. This leaves the balance in the fund tax-free. Once the participant retires, the withdrawn funds are subject to income tax rates. Additional taxes may be applied depending on the details of the plan.

When a contribution is made to a Roth IRA, the money is invested after tax has been taken. This means that the invested money has already been subjected to tax and will not be taxed when withdrawn. The benefits to both options depend on your current employment situation and your future plans.

If you are currently earning a high salary, the money you invest in a traditional IRA will not be taxed and thus lower your gross income. This may help you during the years that you operate in a higher tax bracket. When you retire, this money is subject to income tax. However, because most wealthy employees have lower income tax rates when they retire, they would end up paying less on these withdrawals than they would if they had paid the tax during their employment.

Alternatively, if you do not foresee a large drop in your income tax rate at the time of retirement, you may want to consider a Roth IRA. The money invested in a Roth IRA is taxed at the time it is contributed, resulting in tax-free withdrawals when you retire. Because your tax rate has stayed roughly the same during your employment, it makes little difference when you pay the income tax on your contributions. Having tax-free money during retirement can be seen as an added bonus during a time when a steady income may no longer be available.

Early Withdrawals

There are some cases when early withdrawals on both accounts are allowed. A withdrawal is considered early if the participant is younger than 59-and-a-half years of age. However, there is one major difference in the way each plan oversees its withdrawals. Because the contributions made into a traditional IRA are tax-free, they adhere to stricter withdrawal rules. If a participant makes an early withdrawal from his or her traditional IRA they will be subject to income tax and a penalty of 10 percent. Because the contributions made into a Roth IRA are taxed, they can be withdrawn at any time without penalty. This only applies to the contributions made by the participant and does not apply to any investment profits that might have accumulated through the fund. Subsequently, if a participant withdraws more than just his or her contributions, the money will be subject to taxes and a 10 percent penalty.

Both traditional IRAs and Roth IRAs allow funds to be distributed early for certain expenses. These expenses include higher education payments, such as books and tuition, as well as new homes. Participants in both plans can withdraw $10,000 towards their first home without penalty, if all of the above rules are obeyed.

Eligibility

Participants who are enrolled in a traditional IRA are allowed to contribute as much of their paycheck as they wish, as long as it is below the annual limitations mentioned above. They are, however, restricted in how much of their contribution they can deduct. Here are the 2018 limits for deducting contributions based on modified adjusted gross income levels if you have a retirement plan at work:

Single or Head of Household

  • If your income is less than $63,000, you can deduct the full amount.
  • If your income is between $63,000 and $73,000, you can only deduct a partial amount.
  • If your income is higher than $73,000, you cannot deduct your contributions.

Married and Filing Jointly

  • If your income is less than $101,000, you can deduct the full amount.
  • If your income is between $101,000 and $121,000, you can only deduct a partial amount.
  • If your income is higher than $121,000, you cannot deduct your contributions.

 

Married Filing Separately

  • If your income is less than $10,000, you can only deduct a partial amount.
  • If your income is higher than $10,000, you cannot deduct your contributions.

Roth IRAs have slightly stricter rules on how much an individual can contribute to the fund based on their income. These limitations differ depending on whether the individual is enrolled in another workplace retirement plan. Here are the 2018 contribution limits for Roth IRA incomes if the participant is enrolled in a workplace retirement plan:

Single or Head of Household

  • If your income is less than $120,000, you can contribute the full amount.
  • If your income is between $120,000 and $135,000, you can only contribute a partial amount.
  • If your income is higher than $135,000, you cannot make any contributions.

Married and Filing Jointly

  • If your income is less than $189,000, you can contribute the full amount.
  • If your income is between $189,000 and $199,000, you can only contribute a partial amount.
  • If your income is higher than $199,000, you cannot make any contributions.

Married Filing Separately

  • If your income is less than $10,000, you can only contribute a partial amount.
  • If your income is higher than $10,000, you cannot make any contributions

Distribution Rules

The age at when a participant can withdraw funds from either IRA plans is 59-and-a-half years of age. However, if they are not looking to withdraw their money at that time, they can leave the investments where they are. Traditional IRAs caps this time at 70-and-a-half years of age. When the retiree reaches this age, they are forced to withdraw a minimum amount. Additionally, he or she cannot contribute to their fund after 70-and-a-half years of age.

A Roth IRA imposes no such restriction on withdrawals. The invested money can stay in the account for as long as the participant wishes. Contributions can also be made past the age of 70-and-a-half years.

 

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