The IRA is one of the most powerful tax-advantaged wealth-building tools available to Americans today. There are two types of IRA accounts: the traditional IRA and the Roth IRA. Each account has the same basic goal: retirement planning without as much being paid in taxes.
But these two types of accounts have some important differences that you should know about before you open one and start making contributions.
Let’s explore how this all works and what the differences are between the traditional IRA and the Roth IRA.
What is an IRA?
IRA stands for Individual Retirement Arrangement. The Employee Retirement Income Security Act of 1974 (ERISA) created this account, along with some reforms to the pension system.
An IRA is technically a type of brokerage account with special tax treatment. You as the account owner make contributions to the account and then can select securities inside of the account so that it grows. Some IRAs are not investment IRAs, though. Be careful when you open one that you can actually purchase securities inside it!
This account is under your name and social security number. You can have as many IRAs as you would like. But contributions in a given tax year cannot exceed $6,500 for those under age 50, and $7,500 for those over 50 (as of 2023).
Unlike a 401(k), if you change jobs, you don’t have to do anything to your IRA. With a 401(k), it is generally advisable to take your retirement investments with you to the new job or to roll it into an IRA.
That’s the overview of the IRA generally. But we have two types to talk about. Let’s go through the differences, along with the advantages and disadvantages of both the traditional IRA and Roth IRA.
How Does a Traditional IRA Work?
Under ERISA as originally passed, only the traditional IRA was available. The traditional account allows participants to make tax-deductible contributions. Everyone can take this deduction, regardless of whether they itemize or use the standard deduction.
Traditional IRA Tax Deductions
In 2023, one may take an above-the-line deduction on up to $6,500 of IRA contributions. Those over age 50 may contribute an additional $1,000 each year as per the a catch-up provision ($7,500 total). The tax deduction phases out if you have a retirement plan available at work.
This chart from the IRS website breaks down who qualifies for what deduction based on modified Adjusted Gross Income (AGI) and employer retirement plan availability.
|If Your Filing Status Is…||And Your Modified AGI Is…||Then You Can Take…|
|single, head of household, or qualifying widow(er)||any amount||a full deduction up to the amount of your contribution limit.|
|married filing jointly or separately with a spouse who is not covered by a plan at work||any amount||a full deduction up to the amount of your contribution limit.|
|married filing jointly with a spouse who is covered by a plan at work||$218,000 or less||a full deduction up to the amount of your contribution limit.|
|married filing jointly with a spouse who is covered by a plan at work||more than $218,000 but less than $228,000||a partial deduction.|
|married filing jointly with a spouse who is covered by a plan at work||$228,000 or more||no deduction.|
|married filing separately with a spouse who is covered by a plan at work||less than $10,000||a partial deduction.|
|married filing separately with a spouse who is covered by a plan at work||$10,000 or more||no deduction.|
The deduction is a big upfront benefit. When you invest in securities, the growth happens tax-deferred. Even if you sell, you don’t owe taxes on the growth as long as the money remains in the account.
Traditional IRAs During Retirement Years
When you reach retirement years and start to make withdrawals, this is when taxes become due. There were no taxes on the growth you had inside the account during the accumulation phase. But when you withdraw as a part of your retirement income, that’s where the IRS wants their cut.
Traditional IRAs have required minimum distributions (RMD) starting at age 73. You can use a calculator such as the one on Investor.gov to see what you may have to withdraw. The idea though is that you will be in a lower tax bracket during retirement years than in your working years, saving on taxes overall.
But keep in mind that if you take money out of the account before age 59.5, you will be subject taxation at your highest marginal rate, plus a 10% penalty. So, if your top tax rate is 28%, you will pay 38% in taxes if you withdraw before retirement age. There are only a few very narrow exceptions to this rule.
If you leave your IRA to your spouse after you pass away, your spouse may can keep it as an inherited IRA or roll it into his or her own IRA. But after age 73, RMDs must still continue. Non-spouse beneficiaries must fully withdraw the account within 10 years.
That’s an overview of the traditional IRA, the “OG” plan. Now let’s take a look at its younger sibling.
How Does a Roth IRA Work?
The Roth IRA became available in 1998 after passage of the Taxpayer Relief Act of 1997. The account is named after its sponsor, Senator William Roth of Delaware.
Contrary to the traditional IRA, the Roth IRA does not offer an upfront tax deduction. It also has a few additional rules for making contributions. But the long-term benefits are quite substantial.
Tax-Free Growth in a Roth IRA
Roth IRA contributions have the same limit as traditional—$6,500 or $7,500 (under or over age 50, respectively). For this account, you may only contribute earned income, though. That means, wages, salaries, tips, and self-employment income that is from working.
The most amazing feature of the Roth IRA is that the investments all grow 100% tax-free.
This is especially important because most of the balance in an IRA is compound growth and not contributions. For example, let’s say that you contribute $500 per month into an IRA for 40 years. Averaging 10% per year, that will lead to a balance of about $2.65 million.
Over 90% of that balance is not what you contributed. It’s what your contributions grew into. Only $240,000 is what you contributed over those 40 years. The rest of the balance is compound interest.
Roth IRAs in Retirement
When you get to retirement, you can withdraw from the account without paying any taxes. Because you already paid taxes on that money before you contributed to the Roth IRA.
Like the traditional, you may have taxes and penalties due if you withdraw early. But this only applies to growth. You may withdraw contributions at any time (though I don’t recommend it).
Additionally, Roth IRAs do not have RMDs. You may take a distribution at your discretion.
If you leave a Roth IRA to your beneficiaries, there are still no taxes due. A spousal beneficiary may keep the account or roll it into his or her own Roth IRA. But non-spouse beneficiaries must still fully withdraw the account within 10 years.
Roth Income Qualification
The biggest limitation on Roth IRAs are the income qualifications. This table is from the IRS website and shows what income levels qualify in 2023.
|If your filing status is…||And your modified AGI is…||Then you can contribute…|
|married filing jointly or qualifying widow(er)||< $218,000||up to the limit|
|married filing jointly or qualifying widow(er)||> $218,000 but < $228,000||a reduced amount|
|married filing jointly or qualifying widow(er)||> $228,000||zero|
|married filing separately and you lived with your spouse at any time during the year||< $10,000||a reduced amount|
|married filing separately and you lived with your spouse at any time during the year||> $10,000||zero|
|single, head of household, or married filing separately and you did not live with your spouse at any time during the year||< $138,000||up to the limit|
|single, head of household, or married filing separately and you did not live with your spouse at any time during the year||> $138,000 but < $153,000||a reduced amount|
|single, head of household, or married filing separately and you did not live with your spouse at any time during the year||> $153,000||zero|
To see if you qualify for a Roth IRA, connect with a financial planner in your area.
Final Thoughts on Traditional and Roth IRAs
Creating the IRA is one of the few smart things that Congress has done in the past couple of decades. These accounts, along with the 401(k), offer tremendous wealth-building opportunity for everyday Americans.
As the National Study of Millionaires showed in 2019, the average American millionaire has used tax-advantaged retirement accounts to build the bulk of their wealth. It’s never been easier to build wealth than it is right now. And that’s even with all the obstacles we still face in this world.
If you can’t tell, I am more partial to the Roth IRA than the traditional IRA. The flexibility of distributions when you want and paying no taxes on decades of growth is an incredibly powerful financial tool.
Something I would love to see one day is for Congress to combine the benefits of both accounts into one—a tax deduction upfront and tax-free growth. This would further incentivize retirement investing. It could also stem the tide of the inevitable retirement crisis that is coming due to Social Security’s financial woes.
Bottom line: the time to start is now. And the IRA, traditional or Roth, is a great place to do that.