What we’ll cover:
You’ve probably at least heard of the two main types of Individual Retirement Accounts (IRAs): Traditional IRA and Roth IRA.
The reason there’s a lot of hype around these? Both Traditional and Roth IRAs could help you save money for the future while potentially offering some tax advantages. It’s a win-win.
To level set, IRAs are accounts that any eligible individual can set up to hold investments – think stocks, bonds, mutual funds, etc. For this article, we’re going to focus on Traditional and Roth IRAs, but it’s good to know not all IRAs are the same. There’s SEP IRAs for business owners or those who are self-employed, a Roth IRA you can open for your kids to teach them the importance of saving early on, and inherited IRAs if you’re inheriting another IRA or an employee-sponsored retirement account.
With IRAs, like all retirement accounts, the goal is the same: You put money into that account (contributions), that money generally grows over time (your earnings), and then you take that money out (withdrawals) in retirement.
When it comes to taxes, here’s the main difference between a Roth vs. Traditional IRA:
There are other differences between a Traditional IRA vs. Roth IRA outlined below. If you’re considering opening one, first check your eligibility.
Contributions are made with post-tax dollars. Your withdrawals in retirement are tax free, provided you comply with the withdraw requirements (see below).
Contributions are made with pre-tax dollars and grow tax-deferred until you make withdrawals, which are taxed as income. Contributions may be tax deductible today, depending on income and any work related retirement plan.
Contribute at any age.
Contribute at any age. Prior to 2020, you could only contribute until you’re 70½, but due to a change in the law (the SECURE Act), the age limit has been eliminated.
Withdrawals of your contributions are penalty and tax free, at any age. Prior to age 59½, withdrawals from the interest and/or earnings are subject to income tax and a 10% penalty.
If you withdraw your money prior to age 59½ you’re generally subject to income tax and a 10% penalty. After age 59½ you are subject to income tax but no penalty.
Required Minimum Distributions (RMDs)
You are required to take RMDs in the year you turn 72. Prior to 2020, the RMD age was 70½, but due to a change in the law, that age has been raised to 72. This age increase came into effect on January 1, 2020. For individuals who turned 70½ prior to the effective dated, you are still subject to the old RMD rules. Check with the IRS to get the full details on the timing of your RMD obligations.
For the 2020 tax year, you cannot contribute to a Roth IRA if you’re single and your income is $139,000 or greater, or $206,000 or greater if you’re married filing jointly.
Your contributions may be reduced at other income levels or depending on your filing status. Refer to the IRS table for income limits in 2019 and 2020.
If you’re covered by a retirement plan at work, single and your income is $64,000 or greater, your deduction may be reduced or prohibited.
If you’re covered by a retirement plan at work, married filing jointly and your income is $103,000 or greater, your deduction may be reduced or prohibited.
If neither you or your spouse are covered by retirement plans at work, you can deduct the full amount up to the contribution limit.
Your deductions may be reduced at other income levels or depending on your filing status. Refer to the IRS table for income limits in 2019 and 2020.
If you think you’ll be in a higher tax bracket when you retire, a Roth IRA might work in your favor because you’re paying taxes upfront at a lower rate.
You might also just enjoy the thought of not paying taxes on your retirement income. Assuming you follow the rules associated with a Roth IRA, the money you withdraw is tax-free.
With a Traditional IRA, once you turn 72 you’re required to withdraw a certain amount of money each year from a Traditional IRA. These are known as required minimum distributions (RMDs). With a Roth IRA, you’re not subject to RMDs and are free to withdraw at your own pace.
Additionally, you can continue to contribute to a Roth IRA past this age (also not the case for a Traditional IRA), allowing your savings to grow tax-free.
If you contribute pre-tax earnings to other retirement plans, such as a 401(k), withdrawals from those accounts will generally be considered taxable income. If eligible, having a Roth IRA in the mix might be a good way to diversify your retirement income since you’ll be able to withdraw from that account without paying tax.
Although you should proceed with caution if you’re considering an early withdrawal, accessing money in a Roth IRA ahead of retirement can be a little easier than it would be vs. a Traditional IRA. Contributions to your Roth IRA can be withdrawn at any time, for whatever reason, tax- and penalty-free.
That being said, you may have to pay taxes and penalties on your earnings (the money you’ve made on your contributions). The IRS outlines everything you need to know (including any exceptions), but two main factors are whether you are over or under age 59, and if you’ve held the account for at least five years.
Depending on your circumstances, your contributions to a Traditional IRA may be tax-deductible, which effectively lowers your taxable income.
A lot of this depends on your annual income, tax filing status (single, married filing jointly, married filing separately), and whether or not you’re covered by a retirement plan at work. We know reading up on the IRS rules probably makes your eyes glaze over, but . . . we’d recommend doing so if you’re hoping for a tax-deduction. Otherwise, talk to your tax advisor.
You’re only allowed to contribute to a Roth IRA if you make less than $139,000 individually, or less than $206,000 married, filing jointly (for the 2020 tax year). With a Traditional IRA, you can contribute up to the full amount permitted regardless of your income. However, keep in mind that above a certain income, you may not qualify for a tax-deduction on your contributions.
If you think your income will be lower in retirement than it is now, your effective tax rate may be lower as well. For instance, this could be true if you are in the peak of your career and expect a lower income in retirement. If that’s the case, the potential benefit of a tax deduction today may be worth more than tax-free withdrawals from a Roth IRA.
For some, a Roth IRA can be an obvious choice because of the tax-free withdraws in retirement and overall flexibility. On the flip side, the biggest draw for a Traditional IRA vs. a Roth IRA is the upfront tax break. This may be a great incentive to save for retirement since the tax-deduction potentially helps offset the “cost” of your contributions.
At the end of the day, choosing between a Roth IRA vs. Traditional IRA is your call (just remember to check your eligibility first.) Once you have a solid grasp on the differences between the two, you’ll probably be able to decide what’s best for you.
This article is for informational purposes only and is not a substitute for individualized professional advice. This article was prepared by and approved by Marcus by Goldman Sachs, but does not reflect the institutional opinions of Goldman Sachs Bank USA, Goldman Sachs Group, Inc. or any of their affiliates, subsidiaries or division. Goldman Sachs Bank USA is not providing any financial, economic, legal, accounting, tax or other recommendation in this article. Information and opinions expressed in this article are as of the date of this material only and subject to change without notice. Information contained in this article does not constitute the provision of investment advice by Goldman Sachs Bank USA or any its affiliates. Neither Goldman Sachs Bank USA nor any of its affiliates makes any representations or warranties, express or implied, as to the accuracy or completeness of the statements or any information contained in this document and any liability therefore is expressly disclaimed.
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