Roth IRA vs Traditional IRA: How are they different?
You want to know the differences between a Roth IRA vs Traditional IRA. Before we get into that, I want to say that a rich life doesn’t happen by chance. It does take some careful financial planning.
It’s actually a lot easier that most people assume. Making a few key decisions once and then never worrying about them again can set you on the path to an easy retirement and a rich life, however you define it.
One of those decisions you’ll need to make is getting the right retirement accounts. I know this stuff sounds boring. But you only have to do this once. After that, you can reap the rewards forever.
I’m going to take you through different types of retirement accounts, how they operate, and the best retirement accounts you can open today.
Let’s get right into it.
What is an IRA and How Does an IRA Work?
An Individual Retirement Account or an IRA, as it is popularly called, is an investment account in which you save and invest for your retirement.
You set it up yourself, add money yourself, and pick investments yourself. You’re in complete control.
It is one of the best investing tools you have because it offers fantastic tax benefits. The tax savings are what differentiates an IRA from a regular brokerage account.
You generally invest over a long time for retirement, so even a small tax benefit can have a tremendous impact on how much your money actually grows. Different types of IRAs have different tax saving options (more on that later).
These accounts are so valuable that the IRS limits how much money you can put in them every year. That’s why rule #1 of saving for retirement is to max out your annual IRA investment.
An IRA has some unique features:
- You can invest in a range of instruments like stocks, ETFs, mutual funds, bonds, US Treasuries, and CDs through an IRA.
- The money in an IRA is meant for retirement. So, you will be charged a penalty if you withdraw from it before the age of 59.5 years. This may come across as a negative point, but it cultivates discipline and forces you to stay invested.
- As of 2020, you can contribute a total of $6,000 per year to IRAs. It jumps to $7,000 if you are 50 or older. It may seem like a small amount. But always remember that compound interest is your best friend in investing. Consistent yearly contributions would result in a substantial amount over the years.
The IRA contribution limit changes almost every year, so be sure to check the IRS website to know the latest figures.
A brokerage or a bank is the most common and convenient place where you can open an IRA. You can only contribute to an IRA with your earned income and not income from social security, child support, or investments.
The two most common types of IRAs are a Traditional IRA and a Roth IRA.
Let’s look at them more closely.
Roth IRA vs Traditional IRA – The Key Differences
There are four key differences between a Roth IRA and Traditional IRA.
1. Taxation
The most significant and prominent difference between a Roth IRA and a Traditional IRA is when and how you get taxed.
In a Traditional IRA, your contribution is deducted from your income during the year it is made. You contribute pre-tax dollars. However, you have to pay a tax on the distributions you get according to your tax slab. So you avoid taxes now and pay taxes later.
The Roth IRA is the reverse. You contribute post-tax money but won’t be taxed later when you begin withdrawals during retirement.
Here’s an example: If your annual income is $50,000 and you contribute $6,000 to a Traditional IRA, then your taxable income is $44,000. But in a Roth IRA, your $6,000 contribution is not deducted from your taxable income and it would still be $50,000.
2. Taking Distributions
In a Traditional IRA, you have to start taking required minimum distributions (RMDs) from the age of 72. If you don’t take RMDs then, you will be slapped with an astounding penalty of 50% of the amount not withdrawn.
On the other hand, in a Roth IRA, unless you have inherited the retirement account, you can keep your money in it as long as you wish and let it grow. This flexibility has huge advantages during retirement, giving you more options for taking withdrawals while keeping taxes as low as possible.
…but you don’t have to take the same path as everyone else. How would it look if you designed a Rich Life on your own terms? Take our quiz and find out:
3. Early Withdrawals
I strongly advise against withdrawing money from your IRAs before retirement.
But if you need money urgently for an emergency, it is easier to take it from a Roth IRA. You cannot withdraw your gains but can withdraw the contributions you made without having to pay taxes or a penalty on them. I see this as a major advantage if I run into a serious emergency at some point.
If you dip into your Traditional IRA account before retirement, you’ll have to pay taxes on it in addition to a 10% penalty for withdrawing early.
There are some exceptions to this rule. You can avoid the 10% penalty if you are withdrawing:
- To fund higher education
- Purchase a house (up to $10,000)
- Pay medical bills that are more than 7.5% of your annual income
- Pay your insurance premium if you are unemployed
- Sustain yourself in case of a permanent disability
4. Income Limits
A Traditional IRA technically has no income limitations and you can contribute to it no matter what your income is. But you can only contribute pre-tax dollars if your income is less than $64,000 (single filing) or $103,000 (married filing jointly). The amount of deduction you can claim reduces gradually if your income goes higher.
A Roth IRA has income limitations. As of 2020, if you have an annual income above $139,000 (single filing) or $206,000 (married filing jointly), you cannot make contributions to a Roth IRA.
However, there is a backdoor entry that is approved by the IRS, by which you can contribute to a Roth IRA irrespective of your income.
All you have to do is put money in a Traditional IRA, convert that account into a Roth IRA, pay the required taxes, and then enjoy the tax-free gains in your Roth IRA. And if the Traditional IRA is empty, you skip taxes entirely which allows you to avoid the limits for an Roth IRA.
What Type of IRA is Right For You?
The biggest factor to consider while choosing the type of IRA is how your money is taxed. There’s a lot of debate in the financial world about which IRA offers better tax savings. I strongly recommend you to go for a Roth IRA.
With a Traditional IRA, the distributions post-retirement are taxed according to your tax bracket at that point. If tax rates fall in the future, then your tax liability may reduce.
But it’s hard to predict which way taxes will go. If your career goes well, then it’s very likely that you will be in a higher tax bracket closer to retirement, increasing the tax on the distributions.
On the other hand, the distributions from a Roth IRA are tax-free.
If you bought stocks of Southwest Airlines worth $10,000 in 1970, they would have been worth about $10 million today. These gains would have been tax-free if you had bought them through a Roth IRA if it had been around then. You would have only had to pay tax on your initial investment of $10,000. How good is that?
If the same investment had been made through a traditional IRA, you would have had to pay tax on each distribution of the $10 million, significantly slowing the amount you could withdraw without getting a hefty tax bill.
As you have a longer investment horizon while investing for retirement, you will be better off to make your gains tax free (as they would go up significantly more than the money you have invested) than your contributions.
The only disadvantage of a Roth IRA is that you don’t get an upfront tax deduction. But there’s a way around it. Many people don’t know, but if you contribute to a Roth IRA and have a low to moderate income, you could be eligible for Saver’s Tax Credit and save on $2,000 in taxes every year.
The Best IRA Accounts
An ideal IRA account has low costs, allows automating investments, and has helpful features like 24×7 customer care and excellent fiduciary choices.
Keeping such factors in mind, here are the best 5 IRA accounts you can start:
1. Vanguard
We love Vanguard. They are the pioneers of low-cost investing. Their reputation is stellar as they are the largest brokerage in the world. They offer a large number of funds that you can choose from. But they are all Vanguard funds, so if you want to invest anywhere else, you should look at other names on this list.
- Some funds need a minimum investment of $3,000 to start off
- No account opening minimums
- Low-cost index funds
- Automatic investing
2. Fidelity
Commission-free trades make Fidelity an amazing place to hold your IRA account. Their trading platform is intuitive with many useful tools. Fidelity is amongst the lowest cost brokers if you are investing on your own.
They offer both Fidelity and non-Fidelity funds, making it unique and more diverse. Fidelity also has lots of helpful educational stuff on its website that will add to your financial knowledge.
- Offer some expense-free index funds
- No account opening minimums
- 10,000 no transaction fee mutual funds
- $4.95 trading fee for the rest of the mutual funds
- Excellent 24×7 customer care
- Automatic investing
3. Charles Schwab
Charles Schwab is an excellent all-round brokerage. They particularly stand out because of their superb team of fiduciaries.
- No account opening minimums
- Helpful 24×7 assistance
- No transaction fee for Schwab funds
- $4.95 trading fee for non-Schwab funds
- Automatic investing
- No maintenance fees
- Option to have banking and investments under one roof
4. Betterment
Betterment works like a robo-advisor. It is perfect for someone who prefers a hands-off approach to investing. You only have to let them know about your risk tolerance, and if you want, your desired asset allocation between stocks and bonds. Betterment will do everything from selecting where to invest and rebalancing the portfolio.
For these services, you’ll be charged a 0.25% management fee apart from the fund’s expense ratio.
- No account opening minimums
- Risk-tolerance based investing
- Automatic portfolio rebalancing
- Automatic investing
5. Ally Invest
Ally is an online-only bank. As it doesn’t have to pay for stuff like property, rent, and employees that is associated with physical banks, Ally can afford to give great rates to its customers. It also has a robo-advising tool.
- No account opening minimums
- No maintenance fees
- 24×7 customer service
- Automatic investing
- Digital only
- Low costs
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