Should I Invest in a Traditional or a Roth IRA?

When funded early and consistently, an Individual Retirement Account (IRA) can be a cornerstone of retirement planning. By combining the magic of compounding, a long time for growth, and shelter from taxes, the wealth-building equation can really work in your favor.

But once you decide to fund an IRA, you still have one more choice to make. Should you invest in a Traditional or Roth IRA? This guide will give you an overview of both types to help you choose the best IRA for you.¹

Warning: the post is a tad long. We blame the IRS for making everything so dang complicated.

The Big Difference Between a Traditional and Roth IRA

The primary difference between the two offerings is when the IRS cuts you a break on your taxes.

Traditional IRA owners get instant gratification with tax benefits now. Contributions to a Traditional IRA may be tax-deductible which saves you on taxes now. Until you withdraw from the account, your dividends, interest, and capital gains are safe from Uncle Sam. But the tax man gets his cut when you withdraw money. When you take money out in retirement, it’s taxed at your income tax rate.

Roth IRAs give you major tax benefits later. Unlike a Traditional IRA, you fund the account with after-tax dollars. But your account grows tax free, and you enjoy tax-free withdrawals at retirement age. Even after decades of potential growth, all of your Roth IRA is all yours.

2020 Contribution Limits

For 2020, the maximum combined annual contribution to a Traditional or Roth IRA is $6,000 if you are younger than 50, and $7,000 if you are 50 or older.

One caveat, earned income only: All IRA contributions are limited to earned income. So if you earned $3,000 in taxable income last year, that’s your contribution limit.

Making Your Choice

The tax-free withdrawals on a Roth make it ideal if you expect to be in a higher tax bracket in retirement. You can sock away after-tax savings, let them grow over many years, and then pay zero taxes in retirement on a potentially large account balance.

For this reason a Roth deserves a close look for younger professionals with lower taxes now as they work their way up the tax bracket.

Reverse the advice above to meet the Traditional IRA candidate. If you’re deep into a successful career, your tax bracket has peaked, and you spy lower taxes ahead, the Traditional route may be for you.

The Choice May Be Made For You

Remember when we said the IRS makes things complicated? Well, not everyone qualifies for every type of IRA. Knowing the restrictions on both types of account can help you make the right decision, and may even make the decision for you.

If you make too much, you can’t contribute to a Roth.

If you are a high earner, you may not qualify to contribute directly to a Roth. Each year the IRS sets the limits and they depend on your tax filing status.²

To all my single ladies (and dudes) you can make a:

• full contribution if you make less than $124,000
• partial contribution if you make between $124,000-$139,000
• no contribution if you make more than $139,000

To my married friends who file their taxes jointly, you can make a:

• full contribution if your combined income is less than $196,000
• partial contribution if your combined income is between $196,000-$206,000
• no contribution if your combined income is more than $206,000

So if you make too much money, the IRS won’t let you contribute directly to a Roth IRA. If you want the benefits of a Roth and have a high income, consider a Roth conversion (also known as a backdoor Roth) or contribute to a Roth 401(k) if your company offers one.

Participate in a company retirement account? Traditional IRA contributions may not be deductible.

No matter what you earn, you can contribute to a Traditional IRA. But there’s a catch. (Isn’t there always a catch?)

If you, (or your spouse if married), participate in a retirement plan at work, the IRS sets income limits on who can get those sweet deductions on their taxes.

There are about to be a lot of numbers, but let’s start with the advice:

1. If you can’t deduct your Traditional IRA contribution, contribute to a Roth.
2. If you can’t deduct your Traditional IRA contribution or contribute to a Roth because of high income and access to a 401(k), make it your first priority to max out your employer-sponsored account.
   
   

For 2020, it works out like this:

For single folks with a retirement plan, you can deduct:

• the full amount if you make less than $65,000
• part of your contribution if you make between $65,000-$75,000
• none of your contribution if you make more than $75,000

If you are married filing jointly and you have participate in a retirement plan, you can deduct:

• the full amount if your combined income is less than $104,000
• part of your contribution if your combined income is between $104,000-$124,000
• none of your contribution if your combined income is more than $124,000

And last but not least, if you are married filing jointly and your spouse participates in a retirement plan (but you don’t), you can deduct:

• the full amount if your combined income is less than $196,000
• part of your contribution if your combined income is between $196,000-$206,000
• none of your contribution if your combined income is more than $206,000

There’s No Wrong Answer

Great job. You made it here and are now an honorary IRA nerd. Now don’t let the details bog you down. Make a decision!

Whether you choose a Traditional or Roth IRA, you’re making a smart retirement move. Most importantly, go forth boldly and fund your IRA, trying to max it out every year.

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Notes:
1. Like everything else in the US tax code, the choice between IRAs is complex. Consult with your tax advisor before making a decision, and check the IRS website for in depth and up-to-date treatment of your questions.
2. The IRS regularly updates these limits here. Note that the limits are based on your Modified Adjusted Gross Income (MAGI).