In: Accounting
What is the difference between the tax treatment of contributions and deductions from a traditional IRA and a Roth IRA?
Roth IRA Vs. Traditional IRA: Individual retirement accounts (IRAs) are tax-advantaged vehicles designed for long-term savings and investment—to build a nest egg for one's post-career life. While some IRAs are available through the workplace, the two most common are designed for investors to use on their own: the traditional IRA, established in 1974, and its younger cousin, the Roth IRA, introduced in 1997 and named for its sponsor, Sen. William Roth
While these accounts have similarities—such as the tax-free growth of investments within them—they also differ in some key ways, primarily dealing with tax deductions (do you want to owe the IRS now or later?), accessibility of funds, and eligibility standards.
Tax Breaks:
Both traditional and Roth IRAs provide generous tax breaks. But it’s a matter of timing when you get to claim them.
Traditional IRA contributions are tax-deductible on both state and federal tax returns for the year you make the contribution. As a result, withdrawals—officially known as distributions—are taxed at your income tax rate when you make them, presumably in retirement.
Contributions to traditional IRAs generally lower your taxable income in the contribution year. That lowers your adjusted gross income (AGI), possibly helping you qualify for other tax incentives you wouldn’t otherwise get, such as the child tax credit or the student loan interest deduction.
With Roth IRAs, you don’t get a tax deduction when you make a contribution, so they don’t lower your adjusted gross income that year. But, as a result, your withdrawals in retirement are generally tax-free. You paid the tax bill upfront, so to speak, so you don't owe anything on the back end.
In other words, it's the opposite of the traditional IRA.
You can own and fund both a Roth and a traditional IRA (assuming you're eligible for each); however, your total deposits in all accounts must not exceed the overall IRA contribution limit for that tax year.
Income Limits:
Anyone with earned income who is younger than 70½ can contribute to a traditional IRA. Whether the contribution is fully tax-deductible depends on your income and whether you (or your spouse, if you’re married) are covered by an employer-sponsored retirement plan, such as a 401(k).
Roth IRAs don’t have age restrictions, but they do have income-eligibility restrictions:
For 2019, single tax filers, for instance, must have a modified adjusted gross income (MAGI) of less than $137,000 to contribute to a Roth IRA, with contributions becoming phased out starting with a MAGI of $122,000. Married couples filing jointly must have modified AGIs of less than $203,000 to contribute to a Roth; contributions are phased out starting at $193,000.
For 2020, singles must have a MAGI of less than $139,000, with contributions being phased out starting with a MAGI of $124,000. Married couples must have modified AGIs of less than $206,000 to contribute to a Roth, and contributions are phased out starting at $196,000.
Distribution Rules
Another difference between traditional and Roth IRAs lies with withdrawals. With traditional IRAs, you have to start taking required minimum distributions (RMDs)—mandatory, taxable withdrawals of a percentage of your funds—at age 70½, whether you need the money or not.6 The IRS offers worksheets to calculate your annual RMD, which is based on your age and the size of your account.
Roth IRAs carry no required minimum distributions: You’re not required to withdraw any money at any age—or indeed, during your lifetime at all This feature makes them ideal wealth-transfer vehicles.
Beneficiaries of Roth IRAs don’t owe income tax on withdrawals, either, though they are required to take distributions or else roll the account into an IRA of their own.
Pre-Retirement Withdrawals
If you withdraw money from a traditional IRA before age 59½, you’ll pay taxes and a 10% early withdrawal penalty
You can avoid the penalty (but not the taxes) in some specialized circumstances: If you use the money to pay for qualified first-time home-buyer expenses (up to $10,000) or qualified higher education expenses.10 Hardships, such as disability and certain levels of unreimbursed medical expenses, may also be exempt from the penalty, but you’ll still pay taxes on the distribution.
In contrast, you can withdraw sums equivalent to your Roth IRA contributions penalty- and tax-free at any time, for any reason, even before age 59½.
Now, different rules apply if you withdraw earnings—sums above the amount you contributed—from the Roth. You normally would get dinged on those. If you want to withdraw earnings, you can avoid taxes and the 10% early withdrawal penalty if you’ve had the Roth IRA for at least five years and at least one of the below circumstances applies to you:
If you’ve had the account for less than five years, you can still avoid the 10% early withdrawal penalty if: