Jul 5, 2022
Roth IRA vs. Traditional IRA: Which Is the Better Choice for You?
It’s never too early to start saving for retirement. An Individual Retirement Account (IRA) could help you build your nest egg; it’s a tax-advantaged investment account designed for long-term savings. If you’re debating between a Roth IRA vs. traditional IRA, the two most common types, you’ll want to consider the pros and cons of each. Both offer tax benefits, but they differ in important ways, including the timing of those tax benefits, accessibility of funds, and income limits.
In this article, we’ll cover:
- What a Roth IRA is
- Benefits and disadvantages of Roth IRAs
- What a traditional IRA is
- Benefits and disadvantages of traditional IRAs
- Roth IRA vs. traditional IRA: key similarities
- How to choose the right one for you
- IRA pop quiz
What is a Roth IRA?
A Roth IRA is an individual retirement account you fund with after-tax income. By keeping your money in the account until retirement age, you can reap tax benefits. Your money grows tax-free while it’s in the account, and you don’t pay any taxes on earnings you withdraw after age 59½. Plus, you can withdraw funds you’ve contributed at any time without penalty.
Benefits of a Roth IRA
Saving for retirement with a Roth IRA can have some notable advantages.
1. Tax-free growth and earnings
In exchange for contributing after-tax dollars, your money grows tax-free. Basically, you pay your taxes on contributions up front, let your money compound, and then pay no taxes when you withdraw earnings after age 59½. Note that this tax benefit is subject to the five-year rule: You must hold a Roth IRA for five years or earnings you withdraw may be subject to taxes and penalties. If you have multiple Roth IRAs, once you satisfy the five-year rule for the first one you open, the IRS generally considers the rule satisfied for all of them, even those that you opened more recently.
2. Withdraw contributions penalty-free
You can withdraw money you’ve contributed at any time without paying penalties or additional taxes. That flexibility can be helpful, but keep in mind that it applies to contributions only; any earnings on your investments will usually be subject to taxes and penalties if withdrawn early.
3. No required distributions
Required minimum distributions (RMD) force you to make withdrawals from your account annually starting at a certain age. Roth IRAs don’t have RMDs, allowing your money to compound for as long as you like. You can even pass along the untouched money to your heirs, tax-free.
Disadvantages of a Roth IRA
When you’re considering a Roth IRA, you may want to take into account the potential downsides.
1. Contributions are not tax-deductible
Because you’re contributing after-tax dollars, your annual Roth IRA contribution isn’t tax-deductible at the end of the year, meaning your contributions don’t reduce your taxable income.
2. Taxes and penalties for some withdrawals
While you can withdraw contributions to your Roth IRA without penalty, you may owe income tax and a 10% penalty if you withdraw earnings before you’re 59½ years old. There are, however, a few exceptions to IRA withdrawal penalties.
3. Limited yearly contributions
Roth IRA contributions are limited to $6,000 per year until age 50, at which point you can start contributing up to $7,000 annually. If you earn less than the contribution limit, you can only invest up to the amount of your taxable income for the year.
4. Annual income limits
The IRS restricts your ability to contribute to a Roth IRA based on your income. For instance, most single filers earning more than $144,000 in 2022 are not eligible to contribute to a Roth IRA. The income limit for joint filers is generally $214,000 a year as of 2022. The IRS website provides a complete breakdown of income limits for Roth IRAs.
What is a traditional IRA?
A traditional IRA is also a tax-advantaged investment account for retirement, but it functions a bit differently than a Roth IRA. You contribute pre-tax dollars, and your investments grow tax-deferred until you withdraw them during retirement. Contributions are tax deductible; one possible tax benefit of a traditional IRA is that it can lower your taxable income for the year. After age 59½, you can withdraw your contributions and earnings, and you’ll pay income tax on your money at that time.
Benefits of a traditional IRA
1. Tax-deferred growth
Once the money is in your traditional IRA account, it grows tax-free. Earnings and gains are not taxed until you make a qualified withdrawal during retirement. This can be an appealing tax benefit because many people are in a lower tax bracket after they retire.
2. Tax-deductible contributions
Because traditional IRA contributions are made with pre-tax dollars, you can deduct them from your taxable income; that might put you in a lower tax bracket or make you eligible for certain tax incentives. Note that the amount you can deduct may be limited if you’re covered by an employer-sponsored retirement plan. As of 2022, your deduction amount may be limited if you earn over $68,000.
3. No income limits
Anyone with earned income can contribute to a traditional IRA, regardless of how much you make.
Disadvantages of a traditional IRA
A traditional IRA tends to be a bit less flexible than a Roth IRA. Depending on your circumstances, that might be a disadvantage.
1. Penalties for early withdrawals
Unless you qualify for an exception to early-withdrawal penalties, any withdrawals from a traditional IRA before age 59½ are subject to both income tax and an additional 10% penalty. That applies to both your contributions and gains.
2. Limited yearly contributions
The contribution limits for 2022 are the same as Roth IRAs: $6,000 or $7,000 if you’re over 50.
3. Required minimum distributions
RMDs must be taken from a traditional IRA each year once you turn 72. The RMD for each year is calculated by dividing the IRA account balance as of December 31 of the prior year by the applicable distribution period or life expectancy.
Roth IRA vs. traditional IRA: key differences in 2022
While saving for retirement with either a Roth or traditional IRA can yield tax benefits, there are key differences to be aware of.
|Roth IRA||Traditional IRA|
|Income requirements||$214,000 (joint filers) or $144,000 (single filers). Other limits based on filing status.||None.|
|2022 Contribution limits||$6,000, or $7,000 for ages 50 and older.||$6,000, or $7,000 for ages 50 and older|
|Taxes on contributions||Taxed before contributing.||Taxed at withdrawal.|
|Taxes on earnings||None for qualified withdrawals.||Taxed as income at withdrawal.|
|Tax deductions||Contributions are not deductible.||Contributions are deductible for contribution year.|
|Qualified withdrawals||May began at age 59½. Subject to five-year rule.||May began at age 59½.|
|Taxes on withdrawals||None for qualified distributions. Non-qualified distributions subject to tax and additional 10% penalty tax.||Taxed as income for qualified distributions. Non-qualified distributions subject to tax and additional 10% penalty tax.|
|Early withdrawal rules||No penalty on withdrawal of contributions. Taxes and penalties for withdrawal of earnings. Some exceptions apply.||Taxes and penalties for withdrawal of contributions and earnings. Some exceptions apply.|
|Required Minimum Distributions (RMDs)||None.||Must begin at age 72.|
|Age requirements||There are no age limits on Roth contributions as long as you have earned income.||You can contribute up to age 70 ½.|
Roth IRA vs. traditional IRA: key similarities
Roth and traditional IRAs have many similarities, including:
- Contribution limits: The annual amount you can contribute is the same for either type of IRA. Note that it’s a combined limit; if you have both a Roth and a traditional IRA, the limit applies to the total you contribute to all IRAs you own.
- Early withdrawal exceptions: The IRS provides some exceptions to the early-withdrawal penalties for IRAs, including for the purchase of a first home or paying for certain education expenses.
- Investment options: Your IRA account can hold many types of securities, including stocks, bonds, exchange traded funds, mutual funds, and even real estate. Only collectibles and life insurance are excluded from your investment options.
- Administration: For either kind of IRA, you’ll need to open an account with a brokerage, which will manage your account.
An important reminder: IRAs are not savings accounts. Both Roth and traditional IRAs are investment accounts, and all investment comes with risk, including the risk that you could lose money.
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How to choose the right one for you
You have many options when saving for retirement, and an IRA of any type could offer tax benefits. The difference is the timing.
For many investors, a deciding factor is whether you want to pay taxes now or in the future. You may want to consider whether your annual income and tax bracket is likely to be higher or lower when you retire than it is now.
- If you think you’ll be in a higher tax bracket when you retire, a Roth IRA may be right for you. You’ll pay taxes on your income at a lower rate now, and withdraw those funds, plus earnings, tax-free in retirement.
- If you think you’ll be in a lower tax bracket when you retire, a traditional IRA may be the right choice. You’ll get the tax deductions today, and pay a lower tax rate on your money later.
Another factor to keep in mind is how much flexibility you need when accessing your retirement savings.
- With a Roth IRA, there’s no penalty if you take out the money you’ve contributed, even before you reach retirement. For some people, it’s easier to put money toward retirement if you know you can take some of it out.
- With a traditional IRA, non-qualified distributions incur both tax and a 10% penalty. If you worry you’ll need to withdraw money before retirement, this lack of flexibility might be cumbersome.
At the end of the day, saving for retirement is generally a good idea, and the investment option that’s right for you depends on your current circumstances and goals. The tax benefits of both Roth and traditional IRAs could help your investments grow, so whichever you choose may help you build a brighter financial feature.
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IRA pop quiz: check your knowledge
Test your knowledge of IRAs by answering true or false to the following questions in this quick pop quiz.
With which type of IRA do you pay taxes when you contribute money to the account?
Roth IRA. You contribute to a Roth IRA with post-tax dollars and you contribute to a Traditional IRA with pre-tax dollars.
Which type of IRA requires you to withdraw money from your IRA at a certain age?
Traditional IRA. Traditional IRAs require you to withdraw a certain amount of money at a certain age, called a required minimum distribution (RMD).
At what age are you required to withdraw required minimum distributions from your Traditional IRA?
70 ½. You got it! You’re required to withdraw RMDs at age 70 ½ if your birthday is before June 1, 2019, or age 72 if your birthday is June 1, 2019 or later.
True or False: You can have both a Roth and a Traditional IRA.
True. Just make sure you don’t exceed the annual total contribution limit.
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Can you invest in both a Roth IRA and traditional IRA?
As long as you meet the eligibility requirements, you can invest in both a Roth IRA and a traditional IRA. However, your total combined annual contribution to all your IRA accounts will still be capped at $6,000, or $7,000 if you’re over 50.
What is better: a Roth IRA or traditional IRA?
It depends on your circumstances and goals. A Roth IRA may work well for you if you want more flexibility with your money and you anticipate being in a higher tax bracket when you retire. A traditional IRA may be a better investment option if you want tax deductions now and anticipate being in a lower tax bracket upon retirement.
Can my employer match my IRA contributions?
Employers cannot contribute to your individual Roth or traditional IRA. However, your employer can offer a different type of IRA plan, which may include an employer match. These plans are often used by smaller businesses who want to help employees save for retirement without the costs of more complex plans like 401(k)s.
- Payroll Deduction IRA: This allows you to make contributions to your Roth or traditional IRA through direct deposit from your paycheck. There is no option for an employer match.
- Simplified Employee Pension (SEP): This type of IRA allows an employer to open and contribute to an IRA for you. You cannot make contributions yourself; all the funds come from your employer.
- SIMPLE IRA plan: These plans are designed for small businesses who want to offer an employer match. Your employer is required to make matching contributions; plus, they have to contribute some funds even if you don’t.
How much do I need to retire?
Current recommendations say that you’ll need about 80% of your pre-retirement income annually to maintain your current standard of living. For example, if you make $84,000 a year now, you’ll need to have $67,200 in yearly income for retirement. A retirement calculator can help you see if you’re on the right track to retirement and help you clarify your saving and investing goals.
Disclosure: Stash does not monitor whether a customer is eligible for a particular type of IRA, or a tax deduction, or if a reduced contribution limit applies to a customer. These are based on a customer’s individual circumstances. You should consult with a tax advisor.
1Methodology is based on Stash users through a sample period of April 2018 to July 2019.
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