Smart Money Tips

Roth IRA vs. Traditional IRA: Knowing the Differences and Strategies

  • Roth IRA contributions are made with after-tax money and qualified distributions are tax-free and penalty-free
  • Traditional IRA contributions feature a current-year tax deduction while withdrawals in retirement are taxed as ordinary income
  • Knowing the differences between the two account types helps folks plan ahead and save for the future

One of the best ways to get started saving for retirement is to establish and fund an Individual Retirement Account (IRA). They come in two flavors: Traditional and Roth. 

Traditional IRAs allow you to set aside money on a pre-tax basis while a Roth features after-tax cash contributions. There’s a contribution limit the IRS sets each year as well as income restrictions that you must be aware of. Knowing the rules with these two types of retirement savings vehicles, along with a few savvy strategies, can make your road to financial freedom smoother and faster.

Roth IRA or Traditional IRA: Which Is Better?

Both types of IRAs can be right for you depending on the situation. In general, if you are just starting your career and happen to be in a low-income tax bracket, then maxing out a Roth IRA might be the better play. Here’s the reason: While you do not capture a current-year tax deduction with a Roth contribution, the money once in the account can grow tax-free through your retirement. So, paying a little tax today to avoid taxes in the future often makes sense. While there is no immediate tax break for stashing money in a Roth IRA, you are eligible to withdraw contributions at any time without owing taxes or penalties. Once in retirement, qualified withdrawals are tax-free, which often provides financial peace of mind. There are income limitations that restrict high earners from contributing directly to a Roth IRA, but there is what’s known as the “back door Roth IRA” strategy that can be executed by people in a lofty income tax bracket.

For folks earning a bit more money and in a higher tax bracket, then putting money into a Traditional IRA may be the right strategy since you get a current-year tax deduction on contributions. Unfortunately, the IRS sets a somewhat strict limit on your Modified Adjusted Gross Income (MAGI) in order to be eligible for the deduction. Once in retirement, Traditional IRA distributions are taxed as ordinary income. Also, beginning at age 72 (which increases to age 75 in 2033 due to legislative changes), Traditional IRAs must be withdrawn from through what are known as Required Minimum Distributions (RMDs).

If you are still unsure whether to contribute to a Roth IRA or Traditional IRA, you should ask yourself this question: What do you think your tax rate will be in the future (during retirement) compared with today? If you expect to one day be in a lower tax bracket, go with a Roth IRA for its tax-free benefit later on. If you expect to be in a lower tax bracket in retirement, then choose a Traditional IRA for its immediate tax advantage.

Many individuals and couples find that their income in retirement is reduced compared to their working years. As a result, avoiding tax in the current year via Traditional IRA contributions, then paying tax later would seem to be the smarter play. Of course, nobody knows what future tax rates will be. Also, many taxpayers are ineligible to capture the Traditional IRA tax deduction due to income phaseout limits. 

Contribution Limits & Other Rules to Know

The most you can put into a Roth or Traditional IRA is $6,000 for 2022 and $6,500 for 2023. That goes for total IRA contributions between the two types. If you’re age 50 or older, there are what’s known as “catch-up” contributions that allow for an extra $1,000 to be put into either account.

Another rule regarding the tax-deductibility of Traditional IRA contributions involves if you or your spouse has access to a retirement plan, like a 401(k) or 403(b), through a job. In the end, the IRS might make the Roth vs. Traditional decision for you due to all of the eligibility requirements. 

Finally, after five years of owning a Roth IRA, you may withdraw up to $10,000 of earnings without penalty to pay for a first-time home purchase (and related expenses). Also, there’s leeway for you to take money from a Roth IRA for education costs and even hardship withdrawals, including paying medical expenses, before the usual five-year waiting period and age 59½ retirement age for normal distributions. With a Traditional IRA, you can withdraw up to $10,000 for those reasons, and you would just owe income tax on the distribution.

Comparing Roth IRAs and Traditional IRAs

There are other important features and requirements with both Roth and Traditional IRAs. Understanding the differences may help you decide which account is best for your circumstance.

RuleRoth IRATraditional IRA
2022 Contribution Limits$6,000 ($7,000 if age 50 or older)
$6,000 ($7,000 if age 50 or older)
2023 Contribution Limits$6,500 ($7,500 if age 50 or older)$6,500 ($7,500 if age 50 or older)
2022 Income PhaseoutsSingle tax filers with MAGIs under $144,000 (phaseout starts at $129,000) and MFJ couples with MAGIs under $214,000 (phaseout starts at $204,000) may contributeAnyone may contribute, but being able to earn the tax deduction of Traditional IRA contributions is limited by income thresholds and having a workplace retirement plan
2023 Income PhaseoutsSingle tax filers with MAGIs under $153,000 (phaseout starts at $138,000) and MFJ couples with MAGIs under $228,000 (phaseout starts at $218,000) may contributeAnyone may contribute, but being able to earn the tax deduction of Traditional IRA contributions is limited by income thresholds and having a workplace retirement plan
Age Requirements on Contributions?NoNo
Tax Credit?Eligible for the Saver’s Tax CreditEligible for the Saver’s Tax Credit
Tax TreatmentNo upfront tax deduction; qualified retirement withdrawals are tax-freeCurrent-year tax deduction on contributions; distributions are taxed as ordinary income in retirement
Withdrawal RequirementsContributions may be withdrawn at any time tax-free and penalty-free. Earnings may be withdrawn tax-free five years after your first contribution and at age 59½Normal distributions begin at age 59½ 
RMDsNone, but beneficiaries have RMD rules to followWithdrawals must begin at age 72 under the current law

Why A Roth IRA Is So Valuable

If you qualify, contributing to a Roth IRA is rarely a bad choice for several key reasons.

1. Flexibility around withdrawal rules.

You should strive to never pull money from any of your retirement accounts during your working years. That sounds like a no-brainer, but tough times often happen. With a Roth IRA, it’s totally fine to take some cash from the account – you do not have to worry about owing a 10% early withdrawal penalty or facing an income tax bill on the distribution. Your contributions may be withdrawn at any time tax-free and penalty-free. You can use it almost like an emergency fund. 

But let’s say you only have a Traditional IRA, and you need cash now. The IRS is going to ding you big time. You would owe a 10% early withdrawal penalty along with facing income tax on the distribution. If you are in a high tax bracket, that could mean paying more than 40% to the IRS.

2. Financial freedom in retirement.

Maybe ‘freedom’ is overstating it. But there are certainly fewer restrictions with a Roth. Consider that you are not required to take RMDs like you are with Traditional IRA money (starting at age 72 and increasing to age 75 beginning in 2033). Inherited Roth IRAs do face RMD schedules, however. But once money is in a Roth, you can leave those assets untapped for as long as you’d like.

3. No tax means more money.

Imagine you have $1 million in a Traditional IRA. Sounds pretty good, right? But if your tax rate is, say, 25% (to keep the math easy) then $250,000 goes to the IRS and you keep $750,000. Now, if you had a Roth IRA balance of $1 million, that’s all yours since you do not owe tax when you go to withdraw. 

Of course, disciplined savers can always take the Traditional IRA tax deduction cash and invest that in a taxable brokerage account, but we find few people actually do that. So, making Roth contributions is like a stealthy but real way to save more money on an after-tax basis.

4. Tax diversification.

You have probably heard about portfolio diversification. That is having a broad mix of stocks, bonds, and other assets to smooth out investment returns. But tax diversification is another sound strategy when planning for retirement. Here’s why that’s the case: Since many 401(k)s allow you to build pre-tax savings (including pre-tax employer retirement and profit-sharing contributions), investors commonly end up with large account balances that will one day face income tax liability. 

So, to offset that, if you make Roth IRA contributions, you create some tax ballast in your boat of retirement savings since Roth money won’t be snatched by the IRS when you withdraw in retirement. Also bear in mind that Social Security income is taxable (if your income is high enough).

The Bottom Line

The decision whether to contribute to a Roth or Traditional IRA usually boils down to a comparison of your income tax rate today versus what you think it will be in your retirement years. You must know the rules with each account to determine if Roth or Traditional IRA contributions make more sense each year. Ultimately, getting money into a Roth account can have particular advantages.