Finance

Traditional or Roth IRA? How do you want to grow your money?

Should I Invest in a Traditional or Roth IRA?

For this Pro and Con List question, we’ll take a look at two lists at the same time to help answer the question.

The eligibility rules and tax ramifications of Individual Retirement Accounts (IRAs) can make it confusing to choose the option that is best for you.  Should you invest in a Traditional or Roth IRA? Assuming you are eligible for both types of accounts, the pros and cons of Traditional vs. Roth IRAs are important considerations in determining which investment vehicle makes the most economic sense.

Note: eligibility and contribution limits change every year – always consult a tax advisor to make sure you are working with the most up-to-date information.

Pros of Traditional and Roth IRAs

Flexible investment vehicles 

With both kinds of IRA, you can invest in a number of investment types.  Mutual funds are among the most common choices.  You can also choose individual stocks, bonds, exchange-traded funds (ETFs), Money Market (cash) accounts, and you can even trade options.  Some IRA providers may limit your options, but the IRA account itself allows for great variety. 

Bankruptcy protection

Your contributions are held apart from other personal funds that are susceptible to collection efforts from creditors in the event of personal bankruptcy.  Bankruptcy law protects both Traditional and Roth IRAs up to a total value of $1,362,800.  That amount is adjusted for inflation every three years, with the next adjustment scheduled for 2022.

Traditional vs Roth IRA - which is the best option?
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Pros of a Traditional IRA

Immediate tax benefit

When you make a contribution to a Traditional IRA, the tax benefit is a deduction taken for that same tax year.  Say, for example, that your Gross Income for the tax year is $45,000.  If you make a $2,000 IRA contribution, your Adjusted Gross Income (AGI) drops to $43,000, meaning you owe less in taxes for the year.

Tax-deferred growth

As your Traditional IRA assets grow (hopefully), the gains from that growth are tax-deferred until you start making withdrawals from the account.  For most people, their income level in retirement is lower than it is in their prime working years. That means the IRA withdrawals could be taxed at a lower rate than they would have been in the year in which they were originally earned income.

No income limit for eligibility

With a Traditional IRA, investors can contribute to their account regardless of their income level.  Contributions may not be deductible since that benefit is phased out starting at $64,000 annual income and disappears above $74,000 (as of tax year 2019).  Even if the contribution is not deductible, though, money can still be placed in the retirement account.

Cons of a Traditional IRA

Taxable distributions

Withdrawals from your Traditional IRA, regardless of your age at the time of withdrawal, become taxable income.  Because you realized the benefit of a tax deduction when you made the contribution, meaning you contributed pre-tax dollars, it is now time to pay those taxes.  And you don’t just pay taxes on the money you contributed. You pay taxes on any earnings that your contribution has realized as well.

Required withdrawals

Once you reach age 70 ½, if you have not already started to take money out of your Traditional IRA, you will have to start.  You must take Required Minimum Distributions (RMDs) each year, and the IRS considers the amount withdrawn as taxable income.  If you don’t take your RMD, then the amount that should have been taken out is automatically taxed at 50%.

Contribution cut-off

You must take distributions beginning at age 70 ½. This means you can no longer make contributions to your Traditional IRA once you reach that age, either.

Pros of a Roth IRA

Tax-free withdrawals

This is the biggest advantage of having a Roth IRA, and it is significant.  Qualified distributions from a Roth IRA are tax-free since you invested after-tax money.  This goes for the money earned in your Roth IRA as well, like income from interest, dividends and capital gains.  This is a nice perk for an investor at any age, but for a young investor, the opportunity to realize decades of tax-free investment growth is hard to pass up.

No required withdrawals

Unlike the Traditional IRA, you do not have to start taking distributions from your account at age 70 ½ (or any age for that matter).  The IRS “got its cut” of your earnings up front when you paid taxes prior to the investment.  In exchange, they will let you keep the money (and those earnings!) in your account for as long as you like.

No contribution cut-off

You can continue making contributions for as long as you like.  This provides the additional benefit of allowing you to build inheritance savings late in life if that is a goal.

Cons of a Roth IRA

No immediate tax break

Delayed gratification is not for everyone.  With a Roth IRA, you have to make your contribution with post-tax dollars.  In other words, there is no immediate benefit to putting the money into your retirement account like there is with a Traditional IRA contribution.  You won’t realize your tax benefit until years, or even decades, later.

Income eligibility limits

As you reach higher income levels, your ability to contribute to a Roth IRA decreases or stops altogether.  There is a completely legal backdoor Roth IRA contribution that you can explore, but technically the income eligibility limits exist.

Conclusion

So, should you invest in a Traditional or Roth IRA? Assuming you are eligible for either type of retirement account, the tax-free growth benefit of the Roth IRA makes it the best choice for most investors.  If you need the immediate tax break provided by a Traditional IRA, that choice is available to you.  If your goal, though, is to maximize your retirement savings, then the Roth IRA is probably your best option.  (Always consult with a professional financial advisor for official advice that is specific to your situation.)

Additional Information

The best source for official information about retirement is the irs.gov website. Publication 590-A provides the income eligibility rules for Traditional and Roth IRAs for 2019.  And remember, you can make contributions for the 2019 tax year until the April 15, 2020 tax deadline.

Looking for even more IRS detail for reference? Check out this Comparison Table on the IRS website.

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