Traditional vs. Roth IRA: Which Is the Better Choice?

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Traditional vs. Roth IRA: Which Is the Better Choice?

When it comes to contributing money to an individual retirement account (IRA), you have two main options to consider: Traditional or Roth.

Both kinds of IRAs have the same contribution limit—$5,500 in 2018, with an additional $1,000 “catch-up” contribution available if you’re age 50 or older. You can contribute to one type of IRA or split your contribution between the two types. While both traditional and Roth IRAs offer a tax break, the similarities stop there: They differ on everything from when you receive the tax break and income restrictions to when you must start taking distributions.

Which type of IRA makes sense for you will depend on several factors, including your income, current tax rate, expected future tax rate and long-term financial goals.

Traditional IRA

A traditional IRA provides a tax deduction on contributions for the year in which the contributions are made. So if you put $3,000 in the IRA this year and pay a 33 percent tax rate, you may receive a tax deduction valued around $1,000 on your annual tax return.

Not everyone is eligible to receive the deduction, though. Workers who don’t have access to an employer-sponsored retirement plan can receive the full tax deduction for contributions regardless of how much income they earn. But for those who are covered by a workplace retirement plan, deductions are phased out for single tax filers who earn more than $63,000 in 2018 (and unavailable to those who earn $73,000 or more) and married filers who earn more than $101,000 in 2018 (and unavailable to those who earn $121,000 or more).

You pay no tax on the investment earnings inside the traditional IRA until you withdraw the funds, at which point you will pay ordinary income taxes on all distributions.

You can start taking penalty-free withdrawals from the IRA at age 59½, and you must start taking required minimum distributions (RMDs) at age 70½. You will owe a 10 percent penalty—as well as taxes—on all withdrawals made before age 59½ unless the money is being used for specific purposes, such as a down payment on a first home or to cover a financial hardship.

Roth IRA

Unlike the traditional IRA, you receive no upfront tax break for contributing to a Roth IRA. However, your contributions grow tax-free inside the IRA and you will owe no taxes when you withdraw the savings in retirement. That means a Roth IRA may be a better choice if you expect to be in a higher tax bracket in retirement than you are today.

Roth contributions are subject to income limitations, however. The contribution limit is phased out for single tax filers with a modified adjusted gross income (MAGI) of more than $120,000 in 2018 (and completely phased out at $135,000) and married filers with a MAGI of more than $189,000 (and completely phased out at $199,000).

Contributions to a Roth can be withdrawn at any time—tax- and penalty-free. You must, however, keep records that show how much you’ve contributed. All withdrawals (including both your contributions and your earnings) can be withdrawn penalty-free starting at age 59½. Before age 59½, withdrawing any earnings will trigger a 10-percent early-withdrawal penalty and taxes—unless that withdrawal is being used to buy a first home or due to a disability.

One potentially significant advantage to the Roth: Unlike a traditional IRA—which requires distributions to begin by age 70½—you never have to take distributions from a Roth during your lifetime.

Choosing Wisely

Ultimately, you have to decide whether it’s more advantageous for you to get a tax break today or to wait—perhaps several decades— to benefit from tax-free withdrawals. Talk with your financial advisor to determine which kind of IRA makes the most sense for you based on your personal situation and goals.

If you already have savings in a traditional IRA, you may want to consider converting some of that savings to a Roth IRA by paying taxes on the converted amount in the year of the conversion. Whether that is a wise move depends on several factors—including your tax rate now versus later, the amount of the taxes you would owe on the conversion and your plans for the savings. Your advisor can also help you evaluate whether a conversion makes sense.

 

Prepared by WSJ Custom Studios

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