Contributions to a Traditional IRA offer an upfront tax advantage – you receive a tax deduction on contributions, and investment earnings compound tax-free. Taxes are deferred until withdrawals are made. Roth IRA contributions are the opposite – taxes are paid on contributions, but investment earnings and withdrawals are tax-free.
Here are some factors to consider before investing in an IRA:
If you expect your tax rate to be lower in retirement, choose a Traditional IRA to take advantage of the current tax deduction. If you expect taxes to be higher in the future, choose a Roth IRA to receive future tax-free distributions.
If you are in a high tax bracket (32% and above), you may not have the same income in retirement. In this case you may be better off receiving a current tax benefit. The 2017 Tax Cuts and Jobs Act temporarily lowered tax rates. Assuming rates increase in the future, tax-free Roth distributions would be even more valuable than they are today.
Early Withdrawal Penalties
A major disadvantage of a Traditional IRA is that distributions made prior to age 59.5 will incur a 10% early withdrawal penalty (with certain exceptions). Upon reaching age 72, you are required to take minimum withdrawals (RMDs) from the account, essentially forcing you to pay taxes every year.
With a Roth IRA, contributions can be withdrawn without penalty (earnings in the account must meet a 5-year holding period and a qualifying requirement to avoid a withdrawal penalty). Upon turning age 59.5, all withdrawals will be tax-free. There are no RMD requirements for Roth IRA’s, however, that is not the case for Roth 401(k) plans.
Roth 401(k) Plans
If you exceed certain income limits, you become ineligible to make Roth IRA contributions. However, your employer may offer a Roth option within their 401(k) plan, which bypasses the income restrictions on Roth IRAs. In this case you can make annual contributions of $19,500, plus $6,500 catch-up contributions if you are age 50 or older.