What’s the Difference Between a Traditional IRA and a Roth IRA?

July 15, 2021

If you’re not already invested in either a traditional individual retirement account (IRA) or a Roth IRA, you may be unclear on the difference between them.

  • Both are investment accounts that allow you to save for your retirement.
  • Both include the option of investing in stocks, bonds, and various other types of funds.
  • Both allow you to select the assets in which you’d like to be invested.
  • Both offer tax advantages to their holders.
  • Both allow you to contribute $6,000 a year (if you’re under 50) or $7,000 a year (if you’re over 50).
  • And both can be easily opened through your bank or brokerage.

But there are indeed differences between the two, and knowing them now will help you make an informed decision about which is the right one for you (if not both).

What is a Traditional IRA?

A so-called “traditional IRA” is an individual retirement arrangement as it was originally outlined by the U.S. Employee Retirement Income Security Act of 1974. At the very highest level, with a traditional IRA you don’t pay any tax now on the money you put in the account, instead paying tax on the withdrawals you make years down the line in retirement.

What is a Roth IRA?

The Roth IRA, named after Senator William Roth who co-sponsored the bill that created it in 1989, allows individuals to invest a set amount for retirement without the tax deduction, paying tax on the money today so that it can be withdrawn tax-free in retirement.

That’s the topline on the two. Here are the main differences between traditional and Roth IRAs…

1. Tax breaks

The most notable difference between these two types of accounts is when you’re able to cash in on your tax breaks. No matter which type of IRA you hold, you’re going to receive substantial tax incentives.

And each account offers its own unique advantages… and disadvantages.

Contributions to traditional IRAs, for example, are generally tax-deductible the year that they’re made—both at the state and federal level. Plus, since any contributions you make to your traditional IRA account are immediately deductible, it could help lower your adjusted gross income, which might possible qualify you for other tax incentives for which you would not otherwise be eligible.

However, since the account wasn’t taxed prior to retirement, any withdrawals you make after retirement will be taxed as normal income. And if you make any withdrawals before 59 and a half, you’ll pay a 10% penalty for withdrawing your money early (although there are certain exemptions for medical hardship, first-time home ownership, and higher education).

With Roth IRAs, on the other hand, your contributions are not deductible immediately, which means you won’t see any tax advantages until after your retire. But the advantages you would see are substantial.

Any withdrawals you make from your Roth IRA after you retire generally are not taxed at all—which could make quite a difference during your retirement years, depending on your lifestyle costs and how much other income you pull in.

When Traditional IRAs are Not Tax Deductible

As a general rule, if you’re under 70 and a half, you can open up a traditional IRA. But whatever tax deductions you receive (if any) depends on your (and your spouse’s, if you’re married) total income, as well as whether either of you has an employer-sponsored retirement planthrough an employer.

The tax deduction rules for 2019 are as follows:

  • Your traditional IRA account is fully deductible (regardless of your total household income) if neither your or your spouse (if you’re married) is contributing to a 401(k) or other employer-sponsored retirement plan.
  • If you make less than $74,000 (if filing individually), or $123,000 in total household income (if filing jointly with your spouse), your traditional IRA is still fully deductible, even if you do participate in an employer-sponsored plan.

2. Age restrictions

With traditional IRAs, you must start making required minimum distributions (RMDs) from your account by age 71 and a half, or else be subject to additional fees. And once you reach 70 and a half, you can no longer make contributions to your traditional IRA.

With Roth IRAs, there are no age restrictions to when you can make contributions, and there are no required minimum distributions. Plus, you can withdraw contributions at any age without being required to pay the penalty or taxes. (It’s important to note this rule does not apply to withdrawing earnings, which follow a different set of requirements).

3. Income limits

One of the other major differences between Roth IRAs and traditional IRAs is whether your income affects your contribution rate. With traditional IRAs, your income level doesn’t matter—these are available to open to anyone.

With Roth IRAs, however, your income level may impact your eligibility. If you’re filing single and you made $122,000 or more last year, you may have limited eligibility (or not be eligible at all) to open a Roth IRA account. If you’re married filing jointly and have a combined total income with your spouse of $193,000 or more, your eligibility may also be affected.

No matter your retirement strategy, both traditional and Roth IRAs can add value to your overall portfolio. How much value depends on which account you choose… and your overall retirement needs.

Masterworks is a fintech company democratizing the art market. Our investors are able to fractionally invest in $1mn+ works of art by some of the world's most famous and sought-after artists.