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Traditional and Roth IRAs | What’s the Difference?

Let’s review the differences between Traditional and Roth individual retirement accounts, commonly known as “IRAs”, to help you decide which is the best option for you.  

We have three learning objectives in this post:

  • To understand the differing tax advantages of each type of IRA
  • Understand how participation in an employer-sponsored retirement plan impacts your use of IRAs
  • To determine which type of IRA is best for your situation

First a bit of history.   Traditional IRAs became available in 1974 as part of the Employee Retirement Income and Security Act.  The Roth IRA was created as part of the Taxpayer Relief Act of 1997 and is named for Senator William Roth.

There are a couple fundamental differences between these two forms of individual retirement accounts, but let’s start with what they have in common.  Both types of IRAs offer tax-deferred growth of capital over the years that you contribute and invest inside of the IRA.  This means you don’t have to pay tax each year on the interest, dividends or capital gains you earn.  This is in contrast to a regular taxable bank or brokerage account where you receive a 1099 Form at the beginning of each year which summarizes the taxable income and gains from the previous year that need to be included when you file your tax return.

The Traditional IRA may offer a tax deduction for the amount you contribute each year.  The ability to deduct Traditional IRA contributions depends on whether you or your spouse participate in an employer sponsored retirement plan and your level of income earned in the year in question.   Below the current threshold level of income, you can still deduct your contribution from income to reduce your tax liability.  A phase-out range reduces your deduction based on income until it is fully phased out at the top of the range.  Since these phase-out range income levels are based on your marital status and are adjusted for inflation periodically, I suggest talking with your tax professional or clicking here to review the current income limitations.  If you or your spouse are not covered by an employer retirement plan you can fully deduct your contribution, not matter how much income you have that year.  

Because the Traditional IRA offers a tax deduction when you put money in, there’s a catch.  The catch is that when you take distributions from the account in retirement, the amount of the distribution is considered taxable income and you will receive a Form 1099 – R to account for this on your tax return.  It is possible to make non-deductible contributions to a Traditional IRA and the principal value of these contributions would not be taxed when taken as distributions in retirement.  Distribution of gains on non-deductible IRA contributions are taxable.  I suggest you use a separate Traditional IRA to make non-deductible contributions to if this is your strategy.  Keeping track of deductible vs. non-deductible contributions will be far easier in separate accounts.

Roth IRAs basically work in the opposite manner when it comes to contributions and distributions.   When you make a contribution to a Roth, you will not receive any tax deduction.  Participation in an employer-sponsored plan is irrelevant.  However, there are income limits to be able to make contributions to a Roth for single and joint tax filers.  Since these limits are adjusted for inflation periodically, I suggest talking with your tax professional or clicking here to review the current year income limitations and contribution limits.

When you take withdrawals from a Roth IRA in your retirement years, there is no tax due on the distributions.  A Roth IRA provides the same tax-deferred growth during your saving and investing years and provides tax-free distributions in retirement.  Remember though, there is no immediate benefit of a tax deduction in the year you make contributions.

The big question, of course, is which type of IRA to use for your retirement income planning?   Let’s review some factors for considering your options.  

First, if you or your spouse participate in an employer-sponsored plan, check your level of Modified Adjusted Gross Income to see if you will be able to deduct your contribution for a tax break.  If your income is too high for a deduction, then it makes sense to contribute to a Roth as long as your income is below the eligibility for making Roth contributions.

If you are not participating in an employer plan then the decision becomes a little more difficult.   The tax deduction benefit of a Traditional IRA contribution feels good at the moment, but remember there will be tax due when you take distributions in retirement.  Most people are in a lower tax bracket in retirement so this trade-off may make sense, but no one really knows where tax rates will be 10 or 20 years down the road.

If your income is above the limit to make a Roth contribution, then the Traditional IRA makes sense even if you will not receive a tax deduction.  The big benefit of both types of IRAs is the tax-deferred growth of your investments over time, which allows your IRAs value to compound at higher rates during your accumulation years.

The good news is that with two types of IRAs available, these is a solution that should work for just about everyone when it comes to using these for retirement planning. It is also important to note that any one individual can have both a Roth and Traditional RA at the same time, but annual contributions are capped each year and apply to the total contributed to all IRAs.  No doubling up of contributions is allowed.

If you have questions on the best type of IRA for your retirement planning, you can contact us at 941-778-1900 or email us at: info@integracapitaladvisors.com.

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