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Individual retirement accounts can be a fantastic vehicle for helping individuals save money for retirement.  They can be used in conjunction with workplace retirement plans and social security to help provide income for retirees when they have left the workforce.  When it comes to IRAs, they come in two different flavors, traditional and Roth.  We will discuss how these two types of retirement accounts are the same, how they are different, and which one may be right for you.

How Are They The Same?

Contribution Limits – Regardless of which type of IRA you are investing in, you have the same contribution limits.  For 2017, individuals under 50 can contribute up to $5,500, and individuals over 50 can contribute up to $6,500 in an IRA.  This is a total contribution limit, ie if you have both a traditional IRA and a Roth IRA, your total contributions to both accounts cannot exceed the $5,500 for an individual under 50.  So if 48 year-old Bob deposits $3,000 in his traditional IRA, he could only contribute an additional $2,500 to his Roth IRA.  This amount is adjusted on a yearly basis to account for inflation. 

Eligibility for Contribution – To contribute to a traditional or a Roth IRA an individual must have earned compensation for the year in which they are making a contribution.  You are limited to contributing the lesser of your earned compensation for the year, or the $5,500 contribution limit.  So, if Bob earned $4,000 at a part-time job during the current year, and that was his total earned compensation for the year, he could only contribute $4,000 to his IRA.  One big exception to this is what is called the spousal IRA.  A non-working spouse can contribute to a spousal IRA, provided that the working spouse has earned compensation to cover the non-working spouse’s contribution.  So, here, Bob is a stay-at-home Dad, and his wife Mary had compensation of $40,000 for the year.  Mary could contribute up to $5,500 to her IRA, and Bob could also contribute $5,500 to a spousal IRA.  However, say Mary had compensation of $10,000 for the year and still contributed $5,500 to her IRA.  In this case, Bob would be limited to a $4,500 contribution ($10,000 - $5,500).

Phaseouts – Your eligibility to contribute to traditional and Roth IRAs is phased out as your modified adjusted gross income grows.  What this means is that if your income hits certain levels for the year, the IRS does not allow you to make deductible contributions to traditional IRA accounts or any contributions to a Roth IRA account.  While both types of IRAs have phaseout limits, the limits themselves are different.  The chart below shows the 2017 phaseout limits for the different IRA accounts.

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How Are They Different?

Tax Treatment – The biggest difference between the traditional IRA and the Roth IRA is in how they are treated by the IRS.  A traditional IRA is a tax-deferred account, while a Roth IRA is a tax-advantaged account.  When you make a contribution to a traditional IRA you are able to deduct that contribution from your total income when you file your taxes, lowering your tax liability for that year.  The money in the account then grows, and the taxes on the contributions and the earnings on those contributions are deferred until you begin withdrawing money from those accounts.  The idea being that when you contribute the money you are in a higher tax bracket than when you withdraw the money and therefore pay less in taxes.  With a Roth IRA, contributions are made after taxes, so you are not able to deduct the contribution to lower your tax liability in the year you make the contribution.  Like the traditional IRA, your contributions and the earnings on those contributions continue to grow, but unlike the traditional IRA, when you begin withdrawing from a Roth IRA, you pay no taxes. 

Required Distributions - When it comes to the IRS, you can only put off the tax bill for so long, and thus, traditional IRAs are subject to required minimum distributions.  Once you have turned age 70 ½, you must begin withdrawing money from a traditional IRA and alas pay the taxes on those withdrawals.  The required minimum distributions are calculated using the balance on the account on the last day of the previous tax year, and dividing it by a distribution period from the IRS’s “Uniform Lifetime Table.”  For example, if Bob turned 70 ½ this year, had a balance in his traditional IRA of $100,000 on Dec 31^st of the previous year, and his distribution period from the Uniform Lifetime Table was 25, he would be required to make a minimum distribution of $4000 from his traditional IRA for the year, and this withdrawal will factor into his taxable income for the year.  However, since Uncle Sam does not tax any of your Roth IRA withdrawals, they do not require you to make any minimum distributions, regardless of your age or account balance.

Flexibility on Early Withdrawals – The purpose of both the traditional and the Roth IRA is to support the account holder in retirement and therefore the IRS does impose penalties when distributions occur prior to the account owner turning 59 ½.  If you take a distribution from your traditional IRA before the age of 59 ½, you will owe income taxes on the distribution as well as a 10% penalty on the amount withdrawn.  There are exceptions to having to pay the penalty, and they are listed on the IRS website here.  Roth IRAs have a little more flexibility on early withdrawals because your contributions were already taxed.  To avoid any penalties on a Roth IRA distribution, the account must have been opened for at least five years and you must meet one of the four exception categories; account owner is age 59 ½ or more, the distribution is being used to buy or rebuild a first home, or is due to the death or disability of the account owner.  However, where it differs from a traditional IRA is that the penalty only applies to the portion of the distribution attributable to earnings.  Return of your contribution in a Roth is always tax and penalty free.  The IRS also treats distributions from a Roth IRA as coming from your contributions first, then earnings.  This gives you a little more flexibility if you need to withdraw funds from your IRA prior to turning 59 ½. 

Which One is Right For You?

Well, it depends…I know, not what you wanted to hear, but both accounts have their advantages and which one you invest in can often come down to a discussion of what your goals are for the account and what your personal preferences are.  How much can you benefit now from the tax deduction of a traditional IRA?  How much do you value flexibility?  What do you expect your income to be in retirement?  What other retirement accounts do you have and how will they be used/taxed?  When you start answering these questions, you can often see how one type of retirement account can be a better avenue for you to take.  For example, if you are just starting your professional career and making $35,000, the benefits of deducting your traditional IRA contribution might be low when compared to a married couple making $80,000 per year.  Personally, I am a fan of giving clients flexibility in how to fund their retirement years.  If you have a large 401K balance that consists of tax deferred money you may benefit from having a Roth IRA as well to give you an option of multiple accounts to maximize tax efficient withdrawals in retirement.  Bottom line, they are both excellent vehicles for retirement, and whether you invest in a traditional IRA or a Roth IRA, it is more important that you are saving for retirement and provide yourself the maximum amount of time for your investments to grow and fund the life you want to live in retirement.