From 401(k) plans to annuities, there is no shortage of ways to help people save for retirement. Yet, individual retirement accounts (IRAs) shine through as one of the most versatile vehicles for this very purpose.

What is an individual retirement account (IRA)?  

An IRA (individual retirement arrangement) is an account that comes with various tax breaks and is designed specifically to help fund your retirement. You can also invest in many different types of assets within the account including stocks, bonds, ETFs, and mutual funds. While many different types of IRAs are available, the two most common options are traditional IRAs and Roth IRAs.

What are the key differences between a Roth and a traditional IRA?

A traditional IRA is a tax-deferred account, meaning you’ll pay taxes on a future date. Therefore, any contributions you make are typically funded with pre-tax dollars and earnings grow tax-deferred until you withdraw them in retirement. 

With a Roth IRA, you make contributions using after-tax money. From there, your money can grow tax-free and you won’t pay taxes on withdrawals made during retirement—assuming the account is at least five years old.

Why should you invest in an IRA?

While there are many reasons to invest in an IRA, the most popular one is the aforementioned tax benefits. An IRA can also provide you with access to a wider variety of investment choices than those offered through your employer-sponsored plan—such as a 401(k). What’s more, IRAs can provide a higher degree of flexibility: as you’ll have full control over the account. In contrast, 401(k) plans enable your employer to change plans or limit your investment choices without your approval. Switching jobs may also compel you to move 401(k) funds completely or roll them over into an IRA. There’s no need to worry about these scenarios with an IRA.

How to choose between a traditional and Roth IRA

With respect to choosing one type of IRA over another, a one-size-fits-all approach is simply not feasible.

A common reason why investors sometimes choose a traditional IRA over a Roth IRA is that they assume that when retired, they’ll find themselves in a lower income tax bracket—and will thus enjoy the tax-deferral benefits of these types of plans with withdrawals taxed at a lower rate.

While it’s human nature to assume your gross income will decline in retirement, this doesn’t necessarily mean your taxable income will as well. This is particularly true when you factor in income collected from various sources including Social Security benefits, any freelance or part-time work, and other investments you may have. 

Because your future income is difficult to predict with any certainty, investing in both a traditional and Roth IRA is sometimes the most prudent approach: affording you some level of tax diversification (meaning some assets fully taxed upon withdrawal while others remain tax-free). 

Other IRA considerations

Both IRA options also have eligibility requirements, contribution limits, and other conditions that ultimately factor into decisions regarding which account to open.

IRA eligibility requirements
With a traditional IRA, you can open and contribute regardless of how much money you earn (before the Secure Act 2.0, you had to stop contributing the year you turned age 70 ½). This isn’t the case with Roth IRAs, which feature much stricter income limits.

For example, if you file as a single with a modified adjusted gross income (MAGI) of over $144,000 in 2023, you’re not eligible to contribute to a Roth IRA (likewise, those who file jointly will encounter a maximum MAGI limit of $214,000). If you’re a high-income earner who exceeds these thresholds, you can rely on an IRS-approved method—a backdoor IRA—to fund a Roth IRA. A backdoor Roth IRA is created in several ways, each of which requires converting a portion (or all) of traditional IRA funds to a Roth IRA.

IRA contribution limits
As with many retirement accounts, you’ll need to adhere to several IRA rules. One such example is contribution limits, meaning you can’t just add any amount of money you wish to the account.

If you are under 50 years of age, the maximum annual contribution limit for both traditional and Roth IRAs is $6,500 for 2023 (limits do change annually). If you’re age 50 or older, you can contribute up to $7,500 in 2023. The extra $1,000 for this age group is known as a “catch-up” contribution: offered by the IRS to encourage savings and help ease the financial burden of retirement, especially for those who didn’t save enough when they were younger. Starting in 2024, the $1,000 amount is expected to be adjusted annually for inflation based on the pending legislation of the SECURE 2.0 Act.

Keep in mind that you can also continue to make contributions for the previous year up until the income tax deadline. In other words, you can make a contribution (in any amount, up to the limit) for 2023 up until April 15, 2024.

IRA tax deduction limits
While traditional IRAs are generally funded with pre-tax dollars, you also have the option to fund your account with after-tax dollars and then claim a deduction on your tax return.

If you decide to go this route, just know the IRS imposes income restrictions based on how much you earn and whether you or your spouse currently participate in other qualified retirement plans—such as a 401(k).

For example, if you don’t participate in a retirement plan at work, you can deduct your full IRA contribution regardless of your income. Alternatively, if you do have a retirement plan at work, IRA deductions are limited based on your filing status and modified adjusted gross income (MAGI).

If you file as a single with a MAGI of $73,000 or less and participate in a work plan, you can deduct your full traditional IRA contribution (the MAGI limit is $116,000 for joint filers to receive a full tax deduction). You can also qualify for partial deductions; click here for a full breakdown of corresponding income limits.

Because Roth IRAs are generally funded with after-tax money, you don’t need to worry about tax-deduction limits in this respect.

RMDs
Since a traditional IRA is a tax-deferred account, Uncle Sam requires you to eventually pay taxes on your asset. This is precisely where required minimum distributions (RMDs) come into play. RMDs are the minimum amount of money you must withdraw from an IRA beginning at age 73 (if you reached age 73 on or after January 1, 2023, you must take your first RMD by December 31, 2024 (April 1, 2025 if you exercise your one-time option to delay RMDs). After that, annual withdrawals are due by December 31 each year.

IRA penalties
Roth IRAs allow you to withdraw sums equivalent to the amount you contributed at any time, for any reason, tax-free, and without penalty—even before the age of 59½. However, if you want to withdraw from the earnings or profit portion of your account but are younger than age 59½, you’ll likely incur a 10% early withdrawal penalty and be required to pay taxes on your withdrawal (click here to read about exceptions to this rule).

If you make an early withdrawal (prior to age 59½) from your traditional IRA, you’ll not only pay income tax on that amount but will also incur a 10% penalty on the same. As with Roth IRAs, exceptions do exist.

Where can I open an IRA?

You can open either type of IRA—which will probably take shape as an IRA certificate of deposit (CD)—at almost any bank, credit union, or other financial institution. This is sometimes a good option for people who want to minimize risk and guarantee a return.

Alternatively, you can also open an IRA through your financial advisor or online brokerage: thus enjoying the ability to choose your investments and potentially reap higher returns, albeit with more risk.

The bottom line: Roth vs. traditional IRAs

Choosing between a traditional and Roth IRA depends on your own specific situation. However, it’s not uncommon for investor portfolios to contain both options. If you’re still unsure about which IRA is right for you, consult a financial advisor who can help you establish a comprehensive plan that is best-suited your own unique circumstances.

Still undecided whether to choose a Roth or traditional IRA? Schedule a FREE Discovery call with one of our CFP® professionals.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.