Planning for retirement is challenging. Often, you have to anticipate your future financial situation and estimate your needs well before you’ll begin pulling money from your retirement account. This makes it challenging to choose between a Traditional or Roth IRA. Each offers distinct benefits and drawbacks, largely based on the lifestyle you believe you’ll have, not the one you have today.
If you aren’t sure which option is right for you, here’s what you need to know about Traditional and Roth IRAs.
IRA Contribution Limits
The IRS applies certain rules to funding Traditional and Roth IRAs. First, there’s an annual contribution limit of $5,500 ($6,500 if you are age 50 or older) that applies to all of your IRAs cumulatively. That means you can’t save any more than that amount during a calendar year in IRAs.
Second, Roth IRAs have additional restrictions according to your total household income. You have to make less than a specific dollar amount to be eligible for a Roth IRA at all. Further, some income levels mean you can’t contribute the full $5,500 (or $6,500) to a Roth IRA.
The Roth IRA income limits vary from one year to the next. For 2018, those filing as “married filing jointly” must have a modified AGI under $189,000 to be eligible for a full contribution.
IRA Early Withdrawals
Early withdrawals are handled differently in Traditional and Roth IRAs. If you are under 59 ½ years old and pull money from a Traditional IRA, you’ll be hit with a 10 percent penalty by the IRS. Plus, you’ll owe taxes on the amount you withdrew at your current tax rate.
Roth IRAs don’t have the same penalties. If you pull out your contributions, there isn’t a penalty. However, if you pull any interest earnings within five years of your first contribution, it could be subject to both income taxes and a 10 percent early withdrawal penalty.
Traditional IRAs have rules about when you have to start withdrawing money from the account. Once you are 70 ½, regardless of your financial or employment status, you have to take the required minimum distribution. For many, this isn’t an issue. But, for those who don’t need the money, it can be frustrating as it negatively affects future growth.
Unless you inherit a Roth IRA, there aren’t any mandatory minimum distributions, no matter your age. This means you can leave the money sitting (and earning interest) for as long as you choose.
However, both Traditional and Roth IRAs require you to stop making contributions at age 70 ½, so one account doesn’t have an inherent benefit over the other in this regard.
IRA Tax Benefits
Traditional and Roth IRAs come with different tax benefits. Contributions to Traditional IRAs are tax deductible, allowing you to lower your tax burden today.
Roth IRAs come with tax-free withdrawals instead. You pay taxes on the money you save, but you don’t pay taxes on funds from the account when you start taking distributions. This means you’ll have a source of tax-free income in the future, but your tax bill today doesn’t see any savings.
The Simple Approach to Choosing Between a Traditional or Roth IRA
When it comes down to it, if you think you’ll be in a higher tax bracket once you retire, then choose a Roth IRA. If you anticipate a lower tax burden, opt for a Traditional IRA, unless the minimum distribution requirement negatively affects your plans.
Or, if you’re not sure, contribute some to both. As long as your income and the total of your investments falls below the annual IRS limit, you can put money into both kinds of accounts. This lets you hedge your bets, and you can always favor one over the other if your financial situation changes.
Want to learn more? Check out these excellent articles from Engineering Your Finances:
- Should You Rethink Whether to Postpone Retirement?
- 7 Simple Retirement Savings Hacks
- 6 Great Apps That Help with Retirement Planning