When saving for retirement, an Individual Retirement Account (IRA) is one of the most common investment vehicles considered. When opening one, you’ll need to decide between two options: a Roth IRA and a Traditional IRA.
Below is a chart that outlines some of the key differences between the two, but from a wealth planning perspective, one of the most important things to consider is whether your tax rate will be high prior to retirement and low in retirement; or vice versa.
Here’s why: Roth IRA contributions are made with after tax dollars, so they do not lower your current income tax liability. Assets inside the account grow tax deferred and, assuming you meet the requirements of a qualified distribution, withdrawals are tax free.
This might be beneficial to someone who anticipates several streams of income in retirement because the withdrawals are tax free.
Alternatively, Traditional IRA contributions are made with pretax dollars, so they lower your current income tax liability. Assets inside the account grow tax deferred but distributions from the account are taxed at the then prevailing ordinary income tax rates.
| Traditional IRA | Roth IRA | |
| Income limitation for contributions | No | Yes |
| Tax-deductible contributions | Yes. Fully deductible if neither you nor your spouse is covered by a retirement plan. Otherwise, your deduction depends on your income and filing status. | No. Contributions to a Roth IRA are never tax deductible. |
| Tax-deferred growth | Yes | Yes; tax free if you meet the requirements for a qualified distribution. |
| Required minimum distributions during lifetime | Yes. Distributions must begin by April 1st following the year you reach age 72. | No. Distributions are not required during your lifetime. |
| Federal income tax on distributions | Yes, to the extent that a distribution represents deductible contributions and investment earnings. | No, for qualified distributions. For nonqualified distributions, only the earnings portion is taxable. |
| 10% penalty on early distributions | Yes, the penalty applies to taxable distributions if you are under age 59 1/2 and do not qualify for an exception. | No, for qualified distributions. For nonqualified distributions, the penalty may apply to the earnings portion. (Special rules apply to amounts converted from a traditional IRA to a Roth IRA.) |
| Includable in taxable estate of IRA owner at death | Yes | Yes |
| Beneficiaries pay income tax on distributions after IRA owner’s death | Yes, to the extent that a distribution represents deductible contributions and investment earnings. | Generally no, as long as the account has been in existence for at least five years. |