If a 401(k) is like your parents cooking you dinner (it might be good or bad, but at least it’s easy), Traditional IRAs and Roth IRAs are your opportunity to cook for yourself. You have to open the account on your own, but in return you have the freedom to choose the investments and the tax break that works best for you.
So what should you choose: a Traditional IRA or a Roth IRA? They’re both fantastic accounts with some unique pros and cons, and we’ll break it all down so you can make the right choice for your needs.
Traditional IRA vs. Roth IRA
Traditional IRAs and Roth IRAs are both tax-advantaged retirement accounts that you open on your own, typically through a brokerage company or robo-advisor. They share some common features, but big differences exist in how they are taxed.
With a Traditional IRA, your contributions are generally tax-deductible and your money grows tax-deferred inside the account. But when you withdraw that money in retirement, those withdrawals are taxed as ordinary income. This is typically good for someone in a higher tax bracket now than they expect to be in retirement.
A Roth IRA works in reverse. Your contributions are not tax-deductible, but your money grows tax-free inside the account and your withdrawals are tax-free as well. This is typically good for someone in a lower tax bracket now than they expect to be in retirement.
| Traditional IRA | Roth IRA |
| Tax-deductible contributions | After-tax contributions |
| Taxable withdrawals | Tax-free withdrawals |
| Deduction eligibility depends on income and participation in employer retirement plan | Contribution eligibility depends on income |
| Earnings subject to 10% early withdrawal penalty | Earnings subject to 10% early withdrawal penalty |
| Contributions subject to 10% early withdrawal penalty | Contributions fully accessible without tax or penalty |
| RMDs at age 72 or 73 | No RMDs |
What is a traditional IRA?
A traditional IRA is a tax-advantaged retirement account that allows you to deduct your contributions from your taxable income. Your money grows tax-deferred inside the account and is then taxed when you withdraw it.
It’s an account you open on your own, and it can be especially helpful for people who don’t have a 401(k) or other employer retirement plan. In that case, there is no income limit on contributions or deductions, allowing you to make tax-deductible retirement contributions that wouldn’t otherwise be available to you.
How does a traditional IRA work?
You can open a traditional IRA with just about any brokerage company or robo-advisor. Either way, you can contribute from your personal bank account and invest that money in your own mix of stocks, bonds, ETFs, mutual funds, and even real estate. Or if you choose a robo-advisor, you’ll be invested in one of their automated portfolios.
For 2024, you are allowed to contribute up to $7,000 to a traditional IRA, or up to $8,000 if you are age 50 or above. Take note though that that’s a combined limit across all IRAs. Even if you have multiple IRAs, and even if you have a mix of traditional and Roth IRAs, your total contribution across all IRAs can’t exceed that limit.
There is no income limit on contributions, but you may not be eligible to deduct that contribution if either you or your spouse has an employer retirement plan and your income exceeds certain IRS limits.
If neither you nor your spouse participates in a 401(k) or other employer retirement plan, your traditional IRA contributions are fully tax-deductible. Those withdrawals are fully taxed as ordinary income when you take money out.
If either you or your spouse does participate in an employer retirement plan, your traditional IRA contributions may not be deductible if your income is over the IRS limits. In that case, your entire account balance will still grow tax-deferred and only the earnings will be taxed when you make withdrawals.
Early withdrawals made before age 59.5 are subject to a 10% penalty in addition to taxes. There are some exceptions to the penalty, such as distributions made due to disability, certain unreimbursed medical expenses, or purchasing a first home (lifetime limit of $10,000).
Pros and cons of traditional IRAs
In the right situations, a Traditional IRA can help you save and accumulate more money than you could without that tax deduction. But the fact that your money will be taxed later does add some uncertainty and potential downside to your plan.
“Typically, I would lean towards doing a traditional IRA if you're in a higher tax bracket now versus where you think you'll be in retirement,” says Brian Copeland, CPWA, CFP, Director of Financial Planning at Hightower Wealth Advisors in St. Louis, MO. “You get the tax deduction now and you also get all of the tax-free growth as it's accumulating over time. But the big con is the giant question mark of what our tax rates are going to be in the future.”
Pros
- Tax-deductible contributions. The money you contribute is subtracted from your taxable income.
- Investment flexibility. As opposed to a 401(k), you have a lot of freedom to choose from a wide variety of stocks, bonds, ETFs, mutual funds, and even real estate
- No income limit on contributions. You can contribute to a Traditional IRA no matter how much you make, though your ability to deduct those contributions may be limited.
Cons
- Taxable withdrawals. Your withdrawals are taxed as ordinary income.
- Required minimum distributions (RMDs). Once you reach age 73, the IRS requires you to withdraw a minimum amount each year.
- Early withdrawal penalties. With limited exceptions, any withdrawal you make before age 59.5 will be taxed and subject to a 10% penalty.
What is a Roth IRA?
A Roth IRA is also a tax-advantaged retirement account, but in this case the IRS does not allow you to deduct your contributions. Instead, your money grows tax-free and can be withdrawn completely tax-free as long as you are at least age 59.5 and have held the account for at least five years.
This can be especially valuable for people who are in a lower tax bracket now, allowing you to capitalize on years of tax-free growth for a relatively small cost today. They are also more flexible than Traditional IRAs and can be used for a number of purposes in addition to retirement savings, like college expenses and even as a backup emergency fund.
“The Roth is kind of the holy grail of accounts,” says Russell Hackmann, CFA and President of Hackmann Wealth Partners in Boston, MA. “You’ve got to pay some tax now, but effectively you’ve bought the government out of being your partner in that account. You own the whole account and it grows tax-free forever.”
How do Roth IRAs work?
The logistics of a Roth IRA are similar to a traditional IRA. You open it on your own through a brokerage company or a robo-advisor, contribute from your personal bank account, and can choose from a wide variety of investments.
Your contributions are subject to that same combined $7,000 annual IRA limit, or $8,000 if you are age 50 or older. With a Roth IRA, however, income limits apply whether or not you are participating in an employer plan.
For 2023, married couples filing jointly are phased out of Roth IRA contributions once their income exceeds $228,000. Single filers are phased out once their income exceeds $153,000. In either case, you may be able to get around those limits using the backdoor Roth IRA strategy. You should consult a financial advisor or CPA before doing so, however, as there are multiple potential pitfalls that you’ll want to avoid.
The money you’ve invested within a Roth IRA grows tax-free and can be withdrawn tax-free as long as you meet the qualified withdrawal criteria. This typically means that you’ve held the account for at least 5 years and are at least age 59.5, but withdrawals could also be qualified if you are disabled, if they are made to your heirs upon your death, or if it’s for a first time home purchase (up to a lifetime limit of $10,000).
On top of that, you can withdraw up to the amount you’ve contributed at any time and for any reason without taxes or penalties. This feature gives you a lot of flexibility to use a Roth IRA for just about any goal, though this should be done with caution.
“I would much prefer that people save money in there and leave it for retirement, so you don't want to go into it with that being Plan A,” says Copeland. “But if an emergency did happen, you can always get your contributions back without having to jump through any hoops.”
If you make a non-qualified withdrawal for more than the amount you’ve contributed, the excess will be subject to both taxes and a 10% penalty.
Pros and cons of Roth IRAs
Roth IRAs are a great way to accumulate tax-free money and maintain flexibility as you move through life, but there are some drawbacks to consider as well.
Pros
- Tax-free withdrawals. You can access your money completely tax-free, provided you meet the qualified withdrawal criteria.
- Flexible access. Contributions are accessible tax-free and penalty-free at any time for any reason.
- No required minimum distributions (RMDs). The IRS does not require you to take distributions from a Roth IRA.
Cons
- No tax deduction. You don’t get the benefit of a tax break today.
- Income limits. You may not be able to contribute if your income exceeds the limits.
- Qualified withdrawal rules. You generally have to have held the account for 5 years and be at least age 59.5 before you can withdraw your earnings without taxes or penalties
How to choose the right IRA for you
For the most part, the choice between a traditional and Roth IRA largely comes down to taxes and flexibility.
If you are in a higher tax bracket now than you expect to be in retirement, a traditional IRA may be the right choice. It could also make sense if you’re above the income limits for Roth IRA contributions, especially if you don’t have access to a 401(k). In that case, you’ll at least benefit from the deduction today and years of tax-deferred growth.
A Roth IRA may make more sense now if you’re in a lower tax bracket, especially if you have a long way to go before retirement.
“You have access to these accounts your whole life,” says Hackmann, “and therefore particularly if you're younger and at the earlier earning stages of your career, it's a smart thing actually to pay your taxes early and have your money grow inside of a Roth account, tax-free forever.”
You might also consider using a Roth IRA if you like the flexibility of being able to withdraw your contributions, or if you’re already making pre-tax contributions to a 401(k) and you’d like to diversify with some tax-free money in retirement as well.
You could also choose the best of both worlds. While you are bound by the combined annual contribution limit, you can certainly split that contribution between both types of IRAs.
“I don't think it's a wrong answer to do both,” says Copeland. “You're building different types of buckets with different flexible access. If tax brackets are higher in the future, then you can lean towards withdrawing from your Roth. If tax brackets go down in the future, then you can lean towards taking distributions from the traditional. So just having flexibility is key.”
Traditional and Roth IRAs both offer powerful tax breaks and the flexibility to invest in just about any way you’d like, so you really can’t go wrong.
