What's the difference between a Roth IRA and Traditional IRA?

Roth IRAs are funded with money you've already paid income tax on, but you won't have to pay taxes (e.g. – capital gains) again when you withdraw from a Roth IRA, as long as you're 59.5 years old and have held the IRA for at least 5 years by the time of withdrawal. But there's an income limitation for Roth IRA contributions – you typically need to make under $118,000 (single filer) to qualify for the full $5,500 annual contribution. More info here on income limitation for Roth IRA.

Traditional IRAs do not have an income limitation. Contributions to a Traditional IRA are with "pre-tax" dollars, meaning you can take a deduction from your income for contributions made to a Traditional IRA. Keep in mind you have to take the tax deduction yourself on your tax return, or work with your tax preparer. However, withdrawals (aka "Distributions") from a Traditional IRA are subject to taxes at your tax bracket at the time of withdrawal. So if you anticipate being in a significantly lower income tax bracket by the time you withdraw funds from your Traditional IRA, this can work out in your favor.

Traditional IRAs also have Required Minimum Distributions ("RMD") during your lifetime, more info here. Roth IRAs do not have RMD requirements.

While everyone's tax situation is unique and it's important to spend some time with your tax advisor to make sure you understand your situation clearly, the general rules of thumb for choosing between a Traditional or a Roth IRA are:

  • If you have a long time to go before you plan to start withdrawing money from your IRA, and you think your income tax bracket will be the same or higher when you retire as it is today, then a Roth IRA probably makes sense.
    • This can work well for young workers who aren't at their peak earning years yet.
  • If you think your income tax bracket will be lower when you retire than it is today, you may be better off taking the up-front deduction of a traditional IRA.

If after considering your current and anticipated future income and tax circumstances, and you decide that you prefer to have your retirement funds in a Roth IRA but you currently exceed the income limit for Roth IRA contributions, then you can consider a Traditional IRA to Roth IRA conversion (aka "Backdoor IRA Conversion").

WiseBanyan is not a tax advisor and this should not be construed as tax advice. Please consult your tax advisor before making any tax related decisions.

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