What’s the Difference Between a Roth IRA and a Traditional IRA?
Both a traditional Individual Retirement Arrangement (IRA) and a Roth IRA provide tax relief. The difference is when that relief applies:
- In a traditional IRA, the money you pay into the account is free of tax – you get to deduct it from your taxable income for the tax year in which you contribute it. But you pay tax when you draw money out, presumably after you retire. This approach is called tax deferred.
- But in a Roth IRA, Uncle Sam takes his cut up front – you pay into the account from your after-tax income. But everything you draw from that account after you retire (or even before, in some cases) will be tax-free.
Roth IRAs might sound like a good deal, but it depends on your personal circumstances. Many financial planners advise young people to save as much as they can afford in Roth IRAs, before their income rises above the contribution limit. Generally, because the more you earn the more tax you pay, if you expect your income will be higher in retirement than during your working life, then paying the tax up front with a Roth IRA can mean a lower total tax bill over your lifetime. Alternatively, if you are unsure about your retirement tax status, it can be helpful to diversify with both taxed investment and savings accounts and tax deferred. For example, if you have a tax-deferred 401(k) through your employer, which will incur tax when you draw from it in retirement, you could include a Roth IRA in your retirement planning so that you will be able to take some of your retirement income tax free.1
Two other differences between traditional and Roth IRAs result from the different initial tax treatment:
- When you can access your contributions: With a Roth IRA you can take out your contributions – but not their earnings – at any time without tax or penalty, even before you retire. Earnings can be taken out tax free provided you are over 59½ years old and have held your Roth IRA for more than 5 years.
- Whether you must make withdrawals: With a traditional IRA you must make withdrawals, known as “required minimum distributions,” once you reach 72. But you can leave your money in a Roth IRA for as long as you like.
So, if you are still working in your seventies, or you have income from other sources that you want to reinvest, a Roth IRA could be a good choice.