Traditional vs. Roth IRA
In 1974, the Employee Retirement Income Security Act (ERISA) created the individual retirement account (IRA). The IRA has become one of the most widely used retirement savings vehicles right behind the 401(k). IRAs are tax advantaged investment instruments designed for retirement savings. The original, Traditional IRA created a tax-advantaged savings plan for those not covered by a retirement plan at work. However, not all IRAs are identical. The Roth IRA was introduced in 1997, named after its sponsor, Senator William Roth. The Traditional and Roth IRA are the most common types of IRAs designed for the individual investor. Since their introduction, IRAs have gone through many rule changes and have helped millions of American households save for retirement. Let’s discuss how they work and IRA rules that impact contributions, deductibility, and withdrawals.
IRAs can be invested in a variety of assets, including stocks and bonds, money market accounts, treasury bills, mutual funds, and certificates of deposit. Though Traditional and Roth IRAs share similar characteristics, they do differ in some key features. Let’s compare them and see which one is right for you.
First, contributions to a Roth IRA are made with after-tax money, and any earnings grow tax-free. Contributions to a Traditional IRA are typically tax-deductible. The earnings of the Traditional IRA grow tax-deferred, but are eventually taxed at withdrawal, unlike a Roth.
In order to open and fund an IRA a person must meet certain eligibility requirements. For example, prior to the passage of the SECURE Act in late 2019, persons 70 ½ or older were ineligible to contribute to a Traditional IRA. Currently age limit restrictions do not exist for either Traditional or Roth IRA contributions. Also, IRAs limit contributions to the amount of employment income that was earned by the taxpayer in the contribution year. In addition, the maximum contribution that can be made to either type of IRA is limited to $6,000 for persons under the age of 50. For those over the age of 50 the IRS catch-up provision increases the limit to $7,000. These same contribution limits have been in place since 2019.
The Roth IRA has an income limit with a phase-out provision that reduces or even eliminates contribution eligibility based on your modified adjusted gross income. For 2022, the contribution income phase-out for single taxpayers and heads of household starts at $129,000 and is eliminated at $144,000. For married couples filing jointly the phase-out starts at $204,000 and is eliminated at $214,000.
Traditional IRAs don’t have contribution income limits; however, they do have income limits for how much of a contribution may be tax deductible. First, the full contribution is tax deductible if neither a taxpayer nor their spouse is covered by a retirement plan at work. If covered by a retirement plan at work the deductibility may be reduced. For 2022, the deductibility phase-out range for a single taxpayer is $68,000-$78,000 and for married couples filing joint the phase-out range is $109,000-$129,000. Roth IRA contributions are not tax deductible.
There are several differences with regards to withdrawal rules. To repeat, Roth IRA withdrawals are tax-free as long as you take them after you have reached the age of 59 ½ and met the five year holding period requirement. The five year rule states that in order to withdraw earnings tax and penalty free five years must pass since the first contribution was made to the Roth IRA account. Keep in mind that the 10% early withdrawal penalty only applies to the earnings, there are no penalties on withdrawing the contributions of a Roth IRA. Also, Roth IRAs do not have required minimum distributions, whereas Traditional IRAs do, starting the year you turn 72. Traditional IRA withdrawals are not subject to a five year holding period; however, a 10% penalty applies to both contributions and earnings if withdrawals occur before age 59 ½.
Both types of IRAs offer tax advantages. The key consideration when deciding between a Traditional IRA versus a Roth IRA is estimating what your tax bracket will be in retirement compared to your current situation. Conventional wisdom would suggest that your income will decline in retirement therefore reducing your tax bracket, making the Traditional IRA more attractive. However, that is not always the case. Collecting social security, earning income from investments, and having to take a required minimum distribution might be enough to push you into a higher tax bracket.
In general, if you anticipate higher taxes when you retire, a Roth IRA can be advantageous. If you expect your tax rate to decrease when you retire, the Traditional IRA may be a better option. If you need a little extra help making this decision, Provident Investment Management is here to help.
Dan Krstevski, CFP®