Breaking Down the Differences Between Traditional and Roth IRAs

There are many ways to build a nest egg, with two popular choices being contributing to a Traditional IRA or a Roth IRA, especially in combination with an employer-sponsored retirement plan.

IRAs are designed for long-term savings with some tax advantages built in. Some employers may offer IRAs, but it’s far more common for individuals to open up an IRA on their own.

As common as IRAs are, there are unique considerations for each, especially when it comes to taxes. Most importantly, you’ll need to make your best guess about if you’ll be in the same or different tax bracket when you start to withdraw funds. Let’s take a look at what else you’ll need to consider when looking at contributing to a Traditional or Roth IRA.

Traditional IRA: The Basics

If you are fairly certain that you will be in the same or lower tax bracket when you start withdrawing funds, the Traditional IRA may be a good fit. When contributing, you may be able to make pre-tax contributions, maxing out at $6,000 annually, or $7,000 for those over the age of 50.

Traditional IRAs are open to anyone with earned income, and there is no contribution age restriction. When it comes to withdrawals, they are penalty-free but taxed as current income after age 59 ½. Unlike the Roth IRA, mandatory distributions are required after age 72.

If you withdraw money before you turn 59½, you’ll pay taxes and a 10% penalty. There are extenuating circumstances where you can get out of paying the penalty (but not the taxes). These include if you use the money for qualified first-time homebuyer expenses up to $10,000, for qualified higher education expenses, or unreimbursed medical expenses.

Roth IRA: The Basics

Conversely, if you expect to be in a higher tax bracket when you start your withdrawals, the Roth IRA may be a better route.

The Roth IRA provides you with the opportunity to make after-tax contributions so that your future withdrawals will be tax free. While your contributions will grow tax-free, there will be no current-year tax benefits.

The contribution maximum and lack of age restriction for contributions are the same as the Traditional IRA, but eligibility depends on earned income.When it comes to withdrawing funds, you can do so penalty and tax-free after five years and at age 59 ½. Unlike the traditional route, there are no mandatory distributions.

If you want to withdraw earnings before penalties expire, you can do so for a first-time home purchase, qualified education costs, or certain medical expenses, similar to the Traditional IRA. You can withdrawal if it’s related to a disability or qualified financial hardship. Your estate or beneficiary can also take out the money after your passing.

Investment Options

Although the tax consequences for each account type is different, there are a wide range of investments that work well for both Traditional or ROTH IRAs. As aforementioned, in a Traditional IRA, taxes on investments gains are deferred until you withdraw the funds, while in a ROTH IRA no tax is paid (even on any investment gain!). Investment options that are easily accessible and belong in either type of IRA include individual bonds, stocks, mutual funds, ETFs, CDs, and money market funds, just to name a few.

Investments that probably don’t belong in your IRA include municipal “muni” bonds or US Treasury bonds. While there is no restriction on putting these assets in an IRA, part of their benefit is lost in doing so. The interest from both munis and Treasury bonds offer tax exemptions to investors living in their jurisdiction. They often offer lower interest rates than bonds of similar maturities because of this and there is little to no added tax benefit for holding them in an IRA.

Self-Directed IRAs

If you are looking for even more control over your investment options, you may want to open a Traditional or Roth self-directed IRA (SDIRA). This puts the investor—not the financial institution—in charge of investments. You’ll still be able to invest in the options listed above as well assets not typically found in a retirement portfolio. These include gold, tax liens, franchise businesses, investment real estate, etc. Even cryptocurrency is a possibility

Bottom Line

By making an educated guess as to your future tax bracket status, you can decide which IRA is best for you. No matter which you choose—or if you choose both—keep in mind that IRAs are meant for long-term growth and not intended for short-term goals.

Make a Seamless Transition with Treehouse Wealth Advisors

At Treehouse Wealth Advisors, our clients’ best interest is our top priority—always. We specialize in providing our clients advice on retirement plans, investment management, and other topics vital to long-term financial success. No matter your financial goals, we’re prepared to help you create the life you’ve always envisioned for yourself and your loved ones.

Don’t hesitate to reach out for a second opinion!