One of the most common ways people invest and save for retirement today is through a vehicle known as an individual retirement account (IRA). The two most common types of IRAs are Traditional and Roth, and while they share some advantages (like offering tax-deferred growth of capital over the years that you contribute and invest), they each have their own unique nuances—especially when it comes to how they’re taxed.
Let’s take a closer look at the benefits of Traditional and Roth IRAs.
Benefits of a Traditional IRA
Contributions to a Traditional IRA are made on a pre-tax basis. When you contribute on a pre-tax basis, this reduces your taxable income and may help you move to a lower tax bracket.
For example, let’s say you’re a single tax filer and you make $90,000 in 2022, which puts you in the 24% tax bracket. If you contribute $5,000 to a Traditional IRA, your taxable income would be $85,000 come tax time, which brings you down to the 22% tax bracket.
Before you go all-in with Traditional IRAs, there’s a catch: When you take distributions from the account in retirement, the amount of the distribution is considered taxable income. So, even though you weren’t taxed on the $5,000 in the above example when you put it into your account, you will be taxed on it when you take it out.
It’s possible to make non-deductible contributions to a Traditional IRA, and the principal value of these contributions would not be taxed when taken as distributions in retirement. However, distribution of gains on non-deductible IRA contributions are taxable. It’s suggested that you use a separate Traditional IRA to make non-deductible contributions if this is your strategy. Keeping track of deductible versus non-deductible contributions will be far easier in separate accounts.
Tax Benefits of a Roth IRA
Roth IRAs basically work the opposite way when it comes to contributions and distributions. When you contribute to a Roth IRA using after-tax dollars, you will not receive any tax deduction. However, there are income limits to be able to make contributions to a Roth for single and joint tax filers, and these limits are adjusted for inflation periodically. Then, when you take withdrawals from a Roth IRA in your retirement years, there is no tax due on the distributions.
Using the same example as above, if you make $90,000 in 2022 and contribute $5,000 to a Roth IRA, your taxable income will still be $90,000. But unlike a Traditional IRA, rather than getting a tax advantage when you deposit money, a Roth gives a tax advantage when you withdraw your money.
A Roth IRA provides the same tax-deferred growth during your saving and investing years and provides tax-free distributions in retirement. Remember, there is no immediate benefit of a tax deduction in the year you make contributions, although you could end up saving money in the long run.
Anyone making less than the income limit on Roth IRAs and thinking they may be in a higher tax bracket later in life could benefit from a Roth. These can be great options for people who are looking to retire before age 59 ½, when Traditional IRA and 401(k) funds become available. They can also be a great way to set aside tax-advantaged income to help lower your income taxes in retirement, if you’re able.
Which Type of IRA Is Best for Me?
The big question is, of course, which type of IRA to use for your retirement income planning? First, if you or your spouse participate in an employer-sponsored plan, check your level of modified adjusted gross income (MAGI) to see if you will be able to deduct your contribution for a tax break. If your income is too high for a deduction, then it makes sense to contribute to a Roth, as long as your income is below the eligibility for making Roth contributions.
If you are not participating in an employer plan, then the decision becomes a little more difficult. The tax deduction benefit of a Traditional IRA contribution feels good in the moment, but remember, there will be tax due when you take distributions in retirement. Most people are in a lower tax bracket in retirement, so this trade-off may make sense, but no one really knows where tax rates will be 10 or 20 years down the road.
If your income is above the limit to make a Roth contribution, then the Traditional IRA could be a good option, even if you will not receive a tax deduction. The big benefit of both types of IRAs is the tax-deferred growth of your investments over time, which allows your IRA’s value to compound at higher rates during your accumulation years.
What’s Next?
The good news is that with two types of IRAs available, it’s likely that there’s a solution that works for your retirement planning goals. It’s also important to note that you can have both a Roth and Traditional IRA at the same time, but annual contributions are capped each year and apply to the total contributed to all IRAs. No doubling up of contributions is allowed.
Both Traditional and Roth IRAs are powerful tools to help you prepare for retirement. Work with your financial advisor and a tax specialist to determine if making pre-tax contributions or Roth contributions makes sense for your situation.
