The Difference between a Roth and a Traditional IRA

Published January 25, 2017
Category Fianancial Planning

Choosing between a Roth and traditional IRA account with a Credit Union for your individual retirement plan can significantly determine your long-term savings. Therefore, it is important to understand each one of the two accounts so that you can make an informed decision when settling on one.

What is the major difference between a Roth and traditional IRA?

The main difference between these two plans comes about when you are paying taxes on the earnings and contributions in the account. With the traditional IRA, you have to pay taxes during withdrawal, but not on contributions and growth. But with the Roth IRA, it’s exactly the opposite, as you have to pay taxes on all contributions, but be exempt from taxes during withdrawal; even on the earnings.

Therefore, choosing one between the two accounts mainly depends on your income tax bracket now versus how it will be in the future. If you expect that your tax bracket will be higher in retirement than it is now, a Roth IRA would be the better option to go with.

Other key considerations of the two plans include:

Income limitations

Almost everyone with earned income and younger than 70 ½ years of age can contribute to a traditional IRA, but the same cannot be said for a Roth IRA plan. There are income eligibility restrictions with Roth IRAs. For example, single tax filers must have an adjusted gross income of not more than $132,000 to contribute to a Roth IRA in 2016. You can check out the full income limits here for a complete guide on all other restrictions such as with married couples filing jointly.

Tax incentives

Both plans offer you great tax deductions, but the catch is at what time these deductions take place. With traditional IRAs, you escape paying taxes when you put money in to the retirement account as contributions, while with Roth IRAs, you escape paying the taxes when you take out the money during retirement as withdrawals and earnings.

Your potential future tax rate

As mentioned earlier, choosing between a traditional and Roth IRA greatly depends on your current income tax rate versus that of the future. You need to know whether your expected future tax rate will be higher or lower during retirement than now. With that, you can be able to determine whether the tax rate on Roth IRA contributions (which is the today’s tax rate) is lower or higher than the tax rate on traditional IRA’s withdrawals that you will pay in retirement. For example, given today’s ever low federal tax rates and huge United States deficit, many economists argue that future federal income tax rates are likely to rise; meaning Roth IRAs could be the better option for the long-term goal.

Withdrawal rules for both plans

This is another major difference between traditional and Roth IRAs. With traditional IRAs, you are required to start taking out required minimum distributions (RMDs) upon reaching the age of 70 ½. But with Roth IRAs, you are not mandated to make any withdrawals during your lifetime. Therefore, if you don’t need the money, it will continue to grow in your account (tax-free) throughout your lifetime. This makes the Roth IRA plan a great wealth transfer vehicle as its beneficiaries won’t owe any tax on the withdrawals and can decide to spread out the distributions over many years.

These are basically the key differences between Roth and traditional IRAs. With something as important as retirement, it’s a good idea to do proper research before taking up any plan. And remember, taking up your plan with a Credit Union is the best way to go!