Individual retirement accounts (IRAs) allow anyone with earned income to save and invest for the long term while receiving some tax advantages. These savings accounts can be opened through banks, investment companies and discount or traditional brokerages. Today, doing so online is easy.

At a base level, there are two types of IRAs, traditional and Roth. Traditional IRAs were created by Congress with the Employee Retirement Income Security Act (ERISA) of 1974, the culmination of years of investigation and public attention on the need for pension reform starting in the 1960s. Named for Senator William Roth, Roth IRAs were introduced through legislation in 1997 and built on the concept of the traditional IRA.

The most powerful aspect of any IRA is its tax advantages. However, traditional and Roth IRAs approach tax advantages differently, and it can be confusing, at first, to determine which account is best suited for an individual investor’s needs.

Differences in Tax Advantages

Traditional IRAs offer their tax benefits up front. Contributions made into a traditional IRA are tax deductible in the same tax-filing year up to certain income limits. Money you put into the account in 2021 can be credited to reduce your adjusted gross income for your 2021 tax filing, which may help you qualify for other tax benefits.

Savings in a traditional IRA grow on a tax-deferred basis. Any interest, dividends or capital gains are not taxed while in the IRA. When you start to take the required minimum distributions (RMDs), the withdrawals will be taxed at whatever income bracket you are in at that moment.

The tax rate is not fixed. It will continue to change with your income and age as you approach, enter and live through retirement. RMDs and additional amounts withdrawn will impact how your Social Security benefits are taxed, as well as your Medicare Part B premiums.

Roth IRAs are the opposite in structure of traditional IRAs. Instead of receiving tax breaks for contributions today, you receive your tax breaks in the future if you begin to take distributions.

Contributions to a Roth IRA are not tax deductible. They will not lower your adjusted gross income. However, in contrast to the distributions from a traditional IRA, distributions from a Roth IRA are tax-free.

This is the key difference between traditional and Roth IRAs and the main question that must be answered when deciding between accounts. Does it make more financial sense to realize tax benefits now with a traditional IRA or later with a Roth IRA?

It depends on the best estimate of your tax bracket and future income. Generally, a traditional IRA is better if you think your income is higher now than it will be in the future; take the tax breaks now while your marginal tax rate is higher.

A Roth IRA is better if you think your income is lower now than it will be in the future; take advantage of your lower tax bracket today, so your distributions will be tax-free when you are in a higher tax bracket later.

Keep in mind that other tax credits and deductibles will change in addition to possible income changes. Tax credits for children are another example.

To help you estimate the advantages of choosing a traditional or a Roth IRA, banks, brokerages and personal finance websites have created “calculators.” Charles Schwab’s (SCHW) Roth vs. Traditional IRA calculator uses basic personal information you enter to show an overview your choices.

The “Roth Versus Traditional IRA” InvestoGraphic in the December 2019 AAII Journal walks you through the choice in a visual way.

Remember that eligibility and contribution limits are subject to changes annually and that taxes are complex and personal in general. Any IRA calculator is only an educated guess.

Traditional IRAs vs. Roth IRAs

Differences in Distribution Rules

Traditional and Roth IRAs also differ in how distributions are taken. Traditional IRAs require you to take minimum distributions from the account once you reach the age of 72. It does not matter whether you need the funds.

Required minimum distributions are part of a traditional IRA’s structure because of the tax deductions taken up front. The Internal Revenue Service (IRS) offers worksheets to assist you in determining how much will have to be distributed annually. The distribution rate is based on your age and total funds in the IRA.

Roth IRAs do not require distributions or withdrawals of any kind or amount. You have already paid taxes on the earned income contributed to the account. This structure makes Roth IRAs useful for passing on wealth to beneficiaries, too, who will not owe taxes for distributions.

However, there are different stipulations for control of the funds in an inherited Roth IRA depending on whether the beneficiary is a spouse or non-spouse.

If you need to withdraw contributions from a traditional IRA before the age of 59½, you will likely incur a 10% early withdrawal penalty and taxes. The taxes cannot be avoided but the penalty has certain exceptions.

Contributions can be withdrawn from a Roth IRA at any time, without penalty or taxes. If you want to withdraw earnings on contributions from a Roth IRA, you are subject to taxes and the early withdrawal penalty of 10%. Again, exceptions apply, including the five-year rule, your age, the age of the Roth IRA and how you use the withdrawal.

Differences in Income Limits

Traditional and Roth IRAs are both subject to the annual maximum contribution allowed by the IRS. In 2021, the maximum is $6,000, or $7,000 if you are age 50 or older. This applies on a combined basis, meaning you cannot contribute the maximum to each IRA if you have more than one.

Contributions to Roth IRAs are more restricted than contributions to traditional IRAs. Roth IRAs have income eligibility restrictions on contributions (but not conversions).

For 2021, singles must have modified adjusted gross income (MAGI) below $140,000; contributions are limited over $125,000. For married couples to contribute, they must have MAGI below $208,000; contributions are limited over $198,000.

For further information on limitations, see AAII’s Tax Guide.

There are no eligibility limits for traditional IRAs. Anyone with earned income can make contributions, but there are limitations on the tax deductions you can claim based on your income and your access to an employer-sponsored retirement plan.

Conclusion

Individual investors should take advantage of the tax benefits offered by IRAs if they are eligible. With today’s online resources, it is easier than ever to begin taking advantage of what you as a citizen are entitled to while being encouraged to save and invest for the long term.

Depending on your personal financial situation and goals, a traditional or a Roth IRA may better suit your needs. Mainly, it depends on what tax bracket you are in now and what tax bracket you expect to be in later. Tax and IRA regulations change, but this shouldn’t discourage you from taking advantage of these tax-preferred accounts.

IRS.gov offers many resources to help you make the decision between a Roth and traditional IRA. The bank, investment company or brokerage with whom you open an IRA will also have resources and offer guidance, perhaps at a cost, if you want it.

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