You’ve probably heard of these different account types, but perhaps you never nailed down the key differences. So first, let’s touch on the basics of these two IRA’s (Individual Retirement Accounts) and then we’ll get into the finer details and tax incentives.
If you are under 70½ years of age, you can contribute to a Traditional IRA. Your contributions may be tax deductible, but it depends on your income and if you are covered by a retirement plan through your employer.
Roth IRAs, on the other hand, don’t have an age restriction in regard to contribution abilities. But they do have income-eligibility restrictions. For instance, a single tax filer is required to have a modified adjusted gross income (AGI) of less than $133,000 to contribute a reduced amount to a Roth IRA, as of 2017. But in order for the same unmarried filer to contribute the full amount ($5,500/year for those under age 50 and $6,500/year for those over) his/her income must fall below $118,000. For married couples filing jointly, the combined household AGI must fall below $196,000 and $186,000, respectively.
Both Traditional and Roth IRAs provide generous tax breaks, but it’s all in the timing. At the state and federal level, traditional IRA contributions are tax-deductible for the year you make the contribution. However, when you withdraw the money during your retirement years, for example, you are taxed at the ordinary income tax rate. Conversely, when you contribute to a Roth IRA you are taxed immediately. But earnings within the Roth grow tax free, and the withdrawals are not taxed. In summary, a Traditional IRA allows you to avoid taxes when you put the money in and a Roth IRA allows you to avoid taxes when you take the money out.
With both types of IRAs, you will pay no taxes on the growth of funds within, as long as they remain in the account. Taxes are only relevant on contributions or withdrawals.
The primary difference between a Traditional IRAs and Roth IRAs is if, and when, the money must be withdrawn. For Traditional IRAs, the law requires you to withdraw a certain percentage of the funds once you reach the age of 70½. These mandatory, and taxed withdrawals are called required minimum distributions (or RMDs). Roth IRAs, on the other hand, are not bound by an RMD. You can let the money within the Roth IRA grow tax-free for your entire life, without being forced to withdraw any of it.
The earliest you can withdraw money, penalty-free, from both the Traditional IRA and the Roth IRA is at age 59½. But remember, withdrawals from a Traditional IRA will still be taxed because the contributions were tax deductible. Roth IRAs require that the initial contribution be at least five years before making a withdrawal. You will be taxed if you withdraw any money prior reaching the five year mark, but you will only have to meet this benchmark once. And of course, for a Roth IRA, you will only pay taxes on the money that goes into the account and not on the sum you eventually take out.