Roth IRA vs. Traditional IRA: Retirement Showdown

An IRA, or individual retirement account, offers a tax-advantaged way to sock away money for retirement. There are actually many types of IRAs, but for most people, the choice boils down to two main options: a Roth IRA or a traditional IRA.

If you’re trying to decide whether to contribute to a Roth IRA or a traditional IRA, the very short answer is that a Roth IRA makes sense if you expect to be in the same or higher tax bracket in retirement. If you’re earning a lot now and expect to have a lower tax rate in retirement, then a traditional IRA would probably make more sense.

However, that answer certainly doesn’t hold true for everyone in every situation. So below we’ll get into the crucial differences between Roth IRAs and traditional IRAs, and explain a few situations where it might make sense to choose one over the other.

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Roth IRA vs. Traditional IRA: Main Differences

Both Roth and traditional IRAs are excellent ways to save for your retirement, especially if you don’t have access to an employer-sponsored retirement plan. However, there are some important differences between these two accounts, and they boil down to four main areas: eligibility, contributions, tax implications, and withdrawal rules.

Difference #1: Eligibility

We’ll start with eligibility, since your ability to choose a Roth IRA vs. a traditional IRA will depend on whether you even qualify.

Most people will be allowed to contribute to a traditional IRA. The only requirements are that a) you have earned taxable income during the year, and b) you must not be older than 70½ by the end of the year.

You must also have earned taxable income during the year to contribute to a Roth IRA, but unlike with traditional IRAs, there is no age limit. However, to contribute to a Roth IRA, your income must fall under a certain threshold. Here are the income restrictions on Roth IRAs, based on your 2016 tax filing status:

Single: You can contribute the full amount to a Roth IRA if your modified adjusted gross income (MAGI) is $117,000 or less. If your MAGI is $117,001 to $132,000, you can contribute a reduced amount; if it exceeds $132,000, you cannot contribute to a Roth IRA.
Married filing jointly: You can contribute the full amount if you make $184,000 or less. If your MAGI is between $184,001 and $194,000, you can contribute a reduced amount; if your MAGI exceeds $194,000, you cannot contribute to a Roth IRA.
Married filing separately: Your MAGI cannot be more than $10,000 to contribute to a Roth IRA. If your MAGI is less than $10,000, you can contribute a reduced amount. Note that if you did not live with your spouse during the year, you can use the limits for single filers.

As you’ll note above, you can never contribute the full amount to a Roth IRA if you’re married filing separately, and the limit to make even a reduced contribution is very low.

Related: 2016 IRA Contribution Limits and Rules

Difference #2: Tax Benefits

Traditional IRA: With a traditional IRA, your contributions are tax-deductible the year you make them. However, you’ll pay income taxes on any IRA withdrawals you make in retirement.

This has the potentially beneficial effect of lowering your adjusted gross income during your prime earning years, and delaying your tax obligation until retirement, when you’ll likely be in a lower tax bracket anyway. (Note that you may only be able to deduct part of your traditional IRA contributions — or none at all — if you or your spouse are also covered by an employer-sponsored retirement plan such as a 401(k).)

Roth IRA: A Roth IRA works in almost the opposite way: You pay taxes upfront to avoid paying them in retirement. You contribute after-tax income, meaning your contributions are never tax deductible in the year you make them. However, in retirement, all of your withdrawals are tax-free — including your original contributions and any investment gains.

Difference #3: Contribution Limits

Annual contribution limits are the same for Roth and traditional IRAs — mostly.

If you’re under age 50, you can contribute up to $5,500 a year to your traditional IRA. If you’re 50 or older, you can contribute up to $6,500 a year (sometimes called “catch-up contributions”). Both numbers are regardless of income.

The limits are the same with a Roth IRA, but Roth contribution limits can depend on your income. If you’re under age 50 and are allowed to contribute the full amount (see the “Eligibility” section above), you can contribute up to $5,500 each year. If you’re 50 or older and are allowed to contribute the full amount, you can contribute up to $6,500 a year.

If your income limits what you’re allowed to contribute to a Roth IRA, you’ll need to do some math to figure out your reduced contribution limit.

Difference #4: Withdrawal Rules

There are several rules governing when you can start to withdraw money from your IRA. Here are the crucial differences:

Early withdrawals: If you’re younger than age 59½, you won’t be able to take money out of your traditional IRA without paying a stiff 10% penalty. With a Roth IRA, you can withdraw contributions penalty-free at any time; however, you cannot withdraw earnings penalty-free before age 59½. You must have also have contributed to your Roth IRA for five years to avoid the penalty, regardless of your age.
Required minimum distributions: With traditional IRAs, you will be forced to begin taking money out in required minimum distributions once you reach age 70½. That’s not the case with Roth IRAs, which never require withdrawals during your lifetime.

With both types of IRAs, there are several exceptions that allow you to tap the money for certain situations without paying an early-withdrawal penalty. One of the most popular is the ability to use up to $10,000 toward purchasing your first home (or any home, regardless of whether it’s your first, as long as you haven’t owned a principal residence in two years).

You can also take penalty-free withdrawals from either kind of IRA to pay for qualified educational expenses or medical expenses, or if you opt for substantially equal periodic payments (SEPP).

Related: Four Ways to Use a Roth IRA That Have Nothing to Do With Retirement

Roth vs. Traditional IRA: Which Should I Choose?

Take a look at the chart below for a quick summary of the differences between traditional IRAs vs. Roth IRAs. If you need more help making a decision, we’ll also offer a few common scenarios below to help you choose.

	Traditional IRA	Roth IRA
Age limitations to contribute?	Yes; must be younger than 70½	No
Income limitations to contribute?	No	Yes, cannot make over a certain amount depending on tax-filing status (see “Eligibility” for current limits)
Yearly contribution limit	$5,500 ($6,500 for age 50 and older)	$5,500 ($6,500 for age 50 and older); less for some, depending on income
Contributions tax deductible?	Yes, but potential limitations if you or your spouse are covered by employee retirement plan	No
Withdrawals (including contributions and earnings) tax-free?	No	Yes
Withdraw contributions penalty-free any time?	No	Yes
Conditions to avoid early-withdrawal penalty	Must be 59½ before making withdrawals (contributions and earnings)	Can withdraw contributions anytime, but must be 59½ before withdrawing earnings; must have made contributions for at least five years
Required age when you must begin making withdrawals?	Yes, at 70½	No

Choosing Between a Roth IRA and a Traditional IRA: A Few Case Studies

Assuming you’re eligible to contribute to either a Roth or traditional IRA (you’re younger than 70½, which means you’re eligible for a traditional IRA, and your income is low enough to allow Roth contributions), below are a few situations where one type might make more sense than the other.

Case No. 1: I think my tax rate will be lower (or higher) in retirement.

Assuming you are eligible for both types of IRAs, it’s time to get out your crystal ball. Are you expecting a significant bump in income by the time you retire? Would that increase in income bump you into the next tax bracket? If so, a Roth IRA might be a better choice. While your contributions won’t be tax-deductible now, you’ll be able to make your withdrawals down the road without facing a tax bill that’s made even bigger by your higher tax bracket.

On the flip side, if you’re in a high-income tax bracket now but think you’ll be retiring in a lower tax bracket, a traditional IRA could make more sense. The tax deduction on your contributions might be more valuable to you now, and your tax bill may be more modest in retirement.

Let’s look at a couple of examples using this investment calculator from Scottrade. Assuming moderate growth, putting the maximum $5,500 a year into an IRA for 20 years — or $110,000 in total contributions — would yield $264,000 in retirement savings. How much you ultimately pay in taxes on that money depends on a few factors (not the least of which is whether current tax laws remain unchanged, which we’ve assumed here for simplicity’s sake):

Jim uses a Roth IRA, so he pays full income taxes on his $110,000 in contributions, but will owe no taxes on the $154,000 in investment earnings. Assuming a 20% effective tax rate during his contribution years, he’ll pay a total of $22,000 in taxes on that $264,000, or 8.3%. Even if the balance continues to grow throughout his retirement, he still won’t owe any more in taxes — lowering his overall tax rate further.
Jane uses a traditional IRA, thereby deferring any tax obligations until retirement. Let’s assume that when she hits retirement, her effective tax rate drops from 20% to 10%. That means she pays half the rate that Jim did on her contributions — however, she’ll owe that amount on her investment earnings as well. She’ll ultimately pay $26,400 in taxes on the $264,000, or 10%, and will continue to owe taxes on any further investment gains.

Case No. 2: I might need to tap my IRA before age 59½.

Let’s be abundantly clear: Tapping your IRA early, whether it’s a Roth or traditional IRA, is very rarely a good idea. After all, your money can’t grow unless you’re willing to keep your hands off of it.

However, if you fear that you might need to tap your money early, a Roth will probably be a better choice. That’s because you’re allowed to withdraw your contributions (but not your earnings) at any age without paying an early-withdrawal penalty — after all, you’ve already paid taxes on them.

If you’ve been contributing the $5,500 maximum every year for awhile, that means you’ll have access to a significant pile of penalty-free cash. That’s not the case with traditional IRAs until you’re 59½, and even then, you will have to pay taxes on your withdrawals, too.

Case No. 3: I want my money to grow for as long as possible.

Perhaps you’ve diversified your retirement savings enough to know that you won’t need to tap your IRA for a long time, even past the age of 70½. Maybe you have named a beneficiary for your IRA and want to leave behind as much money as possible when you die.

In both cases, a Roth IRA probably is a better choice than a traditional IRA. That’s because traditional IRAs force you to begin taking withdrawals, called required minimum distributions, once you hit age 70½. If you want your money to keep growing, whether for your own benefit or someone else’s, a Roth will allow that to happen.

Made Your Choice? Now It’s Time to Find a Home for Your Money

If you’ve decided whether a Roth or traditional IRA is best for you, the next step is figuring out where you want to open your account. The Simple Dollar offers a guide to the best IRA Accounts that outlines four popular options, as well as more advice on the Roth IRA vs. traditional IRA question.

If you already have an employer-sponsored retirement account such as a 401(k) and are wondering whether it makes sense to open up an IRA as well, see Roth IRA vs. 401k? You May Not Have to Choose. And if you need advice about 401(k)-to-IRA rollovers, check out our step-by-step primer, see How to Do a 401(k) Rollover.

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