Individual Retirement Accounts (IRA) 101
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If you expect lower taxes in retirement, a traditional IRA could be the way to go. If you expect higher taxes, a Roth might be best. That's because these accounts offer very different tax treatments.
Roth vs traditional: How to choose
When you retire and start drawing money from your investment accounts, do you anticipate that your tax rate will be higher than it is right now?
If you answered “yes,” consider choosing a Roth IRA. In the future you’ll likely be moving to a higher rung of the income ladder, and since withdrawals from a Roth IRA are tax-free, your future flush self won’t owe the IRS when you start drawing income.
If you answered “no,” a traditional IRA may be a better choice. High earners tend to migrate to lower tax brackets upon retirement, so can it make sense for them to take the up-front tax deduction these accounts offer during their working years — and absorb the income tax hit down the road in retirement when their tax rate is lower.
Have no idea how your future tax rate will compare to your current one? Consider splitting the difference: Contribute to both a traditional IRA and a Roth IRA in the same year, which the IRS allows as long as the total amount you sock away is within allowable limits.
How to get started
As long as we’re on a roll, let’s address two final obstacles that keep savers on the sidelines instead of jumping in and reaping the major benefits of setting up an IRA:
1. See if you earn too much money (in the IRS’s opinion): Your income is the key factor in determining a) if you’re eligible to contribute to a Roth (partially, fully or at all); and b) how much of your contribution to a traditional (or regular) IRA you’re allowed to deduct from this year’s taxes.
- Unsure about your tax bracket, see our breakdown on income tax brackets.
- See this Roth and traditional IRA contribution and deduction table.
2. Decide where to open an account: The best way to narrow the vast field of contenders is based on how hands-on you want to be:
DIY types who prefer to manage the investments on their own should focus on discount brokerage firms. Here’s who we deemed top IRA providers for 2018 based on our research.
If you’re more comfortable with an automated service that determines the best investment mix for you based on your goals, then consider a robo-advisor. Here’s our guide to the best robo-advisors.
Still unsure? The key differences in more detail
That hits most of the high points of how Roth and traditional IRAs work and which one best fits your needs.
But beyond the abridged Roth-versus-traditional-IRA discussion, here are deeper dives on the four key ways these accounts differ from each other: Taxes, contribution limits, early withdrawal rules and required minimum distributions.
The biggest difference between a Roth and a traditional IRA is how and when you get a tax break:
- The tax advantage of a traditional IRA is that your contributions are tax-deductible.
- The tax advantage of a Roth IRA is that your withdrawals in retirement are not taxed.
In other words, with a traditional IRA, you pay taxes when you take distributions in retirement (or if you make withdrawals prior to retirement). A Roth IRA operates in reverse: You pay taxes upfront, because your contributions are not deductible. Earnings on your investments grow tax-free in a Roth and tax-deferred in a traditional IRA.
These tables illustrate these accounts in action.
*Assumes a 7% annual return and 30-year time horizon; traditional IRA includes invested tax savings.
Both traditional and Roth IRAs come with eligibility rules and restrictions that determine how much you can contribute. Assuming you’re eligible for both, you can contribute to a traditional and a Roth IRA during the same year, as long as the total amount does not exceed the maximum allowable contribution limit of $5,500, or $6,500 if you’re age 50 and over.
The amount you’re allowed to contribute to a Roth IRA, however, isn’t an all-or-nothing scenario — it’s a “heck, yeah!” “sorta” and “sorry, not this year, cowboy” scenario. Roth contribution limits are based on household income, and those at higher incomes often find themselves squeezed out of Roth eligibility either partially or completely. (See our Roth IRA contribution limits page for details on how much your income will allow you to contribute.)
There are no income restrictions for contributing to a traditional IRAs — titans of industry and everyday workers alike are eligible to open and contribute up to the annual limit — but your income can affect how much of your IRA contribution you’re allowed to deduct from your taxes.
In addition to the size of your paycheck, traditional IRA deductibility takes into account tax filing status and whether you and/or your spouse are covered by an employer’s retirement plan. For details on how this is calculated, see our page on traditional IRA contribution limits.
It’s generally not a good idea to withdraw money from an IRA early, and the rules do a good job of deterring it: You must be at least age 59½ to avoid early withdrawal penalties and taxes. But sometimes dipping into your retirement savings is unavoidable.
When you take money out of a traditional IRA before retirement, the IRS socks you with a hefty 10% early-withdrawal penalty and taxes the money you take out as income at your current tax rate. (See our page on traditional IRA distribution rules for more details, as there are some exceptions to this rule.)
The Roth has better terms for those who break the seal on the retirement savings cookie jar: It allows you to withdraw contributions — money you put into the account — at any time without having to pay income taxes or an early withdrawal penalty. However, there are different rules when it comes to accessing the earnings from your Roth IRA: That money is subject to the five-year rule that states that any earnings withdrawn before your first Roth IRA contribution is at least 5 years old may be subject to income taxes and a 10% early withdrawal penalty.
See our detailed explanation of Roth IRA withdrawal rules for more details and the exceptions that apply to Roth accounts.
Required minimum distributions
Fast-forward to your 70th birthday. Six months after you blow out the birthday candles you’ll be subject to required minimum distributions (RMDs) from your traditional IRA. Remember, the IRS is still waiting to tax that money it has left alone for so long.
Taking RMDs is not a big deal if you’re retired at age 70½ and are already living off your retirement savings. But if you’re a financially flush member of the silver-haired set who doesn’t necessarily need to withdraw funds from the IRA, the requirement is less appealing. Not only will you have to interrupt the growth of what’s in your account by making withdrawals, but if you’re still working and want to contribute more to a traditional IRA, you’re out of luck. No additional contributions are allowed after age 70½.
For those who live long and continue to prosper, the Roth is less stringent: It has no required minimum distribution rules (unless you inherit a Roth IRA — see our Roth RMDs post for details on that). You’re free to let your savings stay put in the account and continue to grow tax-free as long as you live. You’re also allowed to continue contributing to a Roth past the age of 70½. If you’re fortunate enough to not need to tap into the account for income right away and you want to pass on a larger account to your heirs, Roth is the way to go.
» Neither seem like a perfect fit? See our full list of IRA types, which includes some lesser-known options