Roth IRA vs Traditional IRA: Beginner’s Guide

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the millennial money woman blog post "ROTH IRA VS TRADITIONAL IRA"

What's the difference between a Roth IRA vs Traditional IRA? Compare all the key points with our comparison table and find out everything that you need to know.

In this article

The other day, I was talking to one of my peers about opening up a Roth IRA. 

She said she had just started a new position at work, and because she was earning money, she wanted to open an IRA.

Quick Tip: To open and contribute to an IRA, you must have earned income. 

I told her that saving and investing money is a fantastic idea.

But then the conversation became interesting: she wanted to know whether it would be better for her to invest in a Roth IRA over a Traditional IRA. 

Now first things first, let me answer the basic question: 

What is an IRA?


An IRA, or an Individual Retirement Account, is something that anyone can open (it’s not employer-sponsored) as long as that person has earned income up to or in excess of the amount that you contribute to your IRA.

In other words, if you earn $1,000 a year, you can’t contribute $5,000 to your IRA. 

The maximum amount you can contribute is $1,000 – or the amount you earned.

Depending on the type of IRA that is opened, you may have certain restrictions as it relates to how much money you can withdraw from the IRA in any given period, how the money is taxed, and whether there are any penalties associated with you taking out the money prematurely. 

However, let’s keep this blog post simple and we can move into the nitty-gritty details later.

The last big picture item you should know about IRA’s is this:

IRA Contribution Limits 2020


The contribution limit is the maximum amount of money you can contribute to an IRA (traditional or Roth) in any given year (assuming you have the earned income, as our previous example shows). 

Let’s get to the facts:

  • Contribution limits are the same for a Roth & Traditional IRA.
  • Contribution limits could increase each year, or over several years – so make sure you ask your accountant as to the contribution limits.
  • If you are under 50 years old, the contribution limit for 2020 is $6,000.
  • If you are 50 years old or older, the contribution limit for 2020 is $7,000.

Now, let’s discuss the reason why you actually came to this blog post: Roth vs Traditional IRA

ROTH IRA VS TRADITIONAL IRA 1

Roth IRA vs Traditional IRA


As you decide to open an IRA, the first question you should be asking yourself is whether it should be a Roth or a traditional IRA.

This is a big decision. 

Consider the words “Roth” and “Traditional” to be adjectives. 

They describe the actual type of account you are opening: it could be an IRA, as described previously, or it could be a 401k as well.

Although we’ve prepared a fancy chart below for you to compare Roth versus Traditional IRA accounts, below are some key big picture items that should help you better determine whether a Roth or a Traditional IRA (or 401k) is best for you.

Big Picture Ideas:

  • A Roth account (IRA or 401k) means you contribute your money on an after-tax basis. This means you pay taxes on the money that you put into the account.
  • A Traditional account (IRA or 401k) means you contribute your money on a pre-tax basis. This means you have NOT yet paid taxes on the money that you put into the account (meaning less money out of your pocket in the present day). 

What’s the catch you may ask? 

Well, Uncle Sam sure wants his money back at some point, so you’ll be required to pay taxes on any of the money you take out. 

Let’s say you want to outsmart Uncle Sam and not take out any money and leave it for your grandkids. 

Not so fast, if you don’t take out money, then Uncle Sam will still require you to take out your money starting at age 72 (this rule recently changed from 70.5).

The general rule of thumb is that you should contribute to your Roth account when you are young and not earning a substantial income – with the assumption being that you will earn more money in your older years.

Why? Typically you are in a low tax bracket in your younger years (you are just starting out your working career, so you are likely not earning as much money). 

If you are in a lower tax bracket, then your tax liability (your tax bill, what you owe to the IRS) will not be as high as if you were earning well into the six-figure numbers right?

In other words, it would be better to contribute your money to a Roth IRA or 401k in your lower earning years so that when you are in your higher-earning years you can take advantage of all that tax-free money that has accumulated in your Roth account. 

Remember, because you already paid taxes on the money in your Roth account, you will never have to pay taxes on this amount again – including any investment earnings.

  • A Roth IRA means any money you contribute or accumulate within the account (assuming it has been 5-plus years since you opened your Roth IRA) will be tax-free to you, upon withdrawal. 

In other words: the money in your Roth account is actually your money.

  • A Traditional IRA means any money you contribute or accumulate within the account will NOT be tax-free to you, upon withdrawal.

In other words: the money in your traditional account is NOT actually the account value that goes to you… because you’ll have to pay taxes on that money at some point when you take it out.

Things to keep in mind before you start your investing journey:

  • Because Roth IRAs are attractive to people who hate the idea of paying taxes later in their lives, there are unfortunately income restrictions that go along with opening a Roth IRA (not a Roth 401k).
  • Roth 401ks are much less common than traditional 401ks, so make sure you ask your employer before enrolling if there is an option to open a Roth 401k.
  • If you are in a higher tax bracket, then it may make sense to take advantage of the pre-tax traditional account (in other words, you are deferring paying taxes now and will promise the government you will pay taxes later when you take out the money of your traditional account). The only thing you have to keep in mind here is that the amount of money in the traditional account is not actually the amount of money that will go into your pocket because of taxes.
  • Always consult your accountant or CPA to discuss whether it would be more advantageous to open a Roth or Traditional account. In the end, they are the ones that know the details of your personal financial situation, so they will know what would be best for you. 

Now that you’ve heard my spiel, let’s look at how a traditional and Roth IRA differ from each other, and how one over the other may be a better choice for you. 

Keep in mind, 401ks have different rules, which we will blog about in a future post. 

However, if you are interested to read about the difference between a Roth 401k and a traditional 401k, click here.

Roth IRA Traditional IRA
Contribution Restrictions
Below age 50: $6,000 Age 50 and older: $7,000
Below age 50: $6,000 Age 50 and older: $7,000
Income Limitations for contribution eligibility
If filing single: $124,000 - $139,000 (phase-out) for 2020 If married filing joint: $196,000 - $206,000 (phase-out) for 2020
No income limits for contribution eligibility (but there are certain income limits for deductibility eligibility)
Age restrictions
None
None
Tax status
After-tax
Pre-tax

Penalties if you withdraw from your contributions*

No
Yes – you withdraw before age 59.5 Certain restrictions apply, and I would suggest for you to talk to your accountant for further information

Penalties if you withdraw from your earnings?*

No – assuming it has been 5 years AFTER your first Roth contribution and you are over age 59.5 or become totally disabled or died or meet requirements for a first-time home purchase
Yes if withdrawn before age 59.5
Required Minimum Distributions (RMDs)?
No
Yes, starting at age 72
Contribution deadline
Tax filing deadline (this does NOT include tax filing extensions)
Tax filing deadline (this does NOT include tax filing extensions)

Investment Options**

Unlimited
Unlimited

Definitions:

*1. Contributions  Refers to the amount of money you invest initially. 

Let’s say you invest $1,000 and don’t add or withdraw from that contribution. After 5 years, your account has grown to $1,500. The contribution still is the $1,000 because that was the amount of money YOU contributed. 

*2. Earnings Referring to the example above, earnings concerns any growth on top of your original contribution / investment. 

So, if your contribution was $1,000 and you don’t touch your account, after 5 years you see $1,500 in your account, then your earnings are $500.

**3. Investment Options Simply refers to any type of option you can  invest your money. 

For IRA purposes, you can literally invest your money in virtually anything you’d like (99% of the time). To compare, a 401k has limited investment options – so you are restricted into which funds you decide to allocate and invest your money.  There is more flexibility for investing purposes with IRAs.

Roth IRA – tax deductibility:

  • None

Traditional IRA – tax deductibility:

  • If filing single – and you can contribute to an employer sponsored retirement plan (such as a 401k): $65,000 – $75,000 for 2020
  •  If filing single – and you cannot contribute to an employer sponsored retirement plan: No income limit
  • If married filing jointly – and you can contribute to an employer sponsored retirement plan (such as a 401k): $104,000 – $124,000
  • If married filing jointly – and you cannot contribute to an employer sponsored retirement plan (like a 401k) but your partner is able to contribute to an employer sponsored retirement plan: $196,000 – $206,000
  • If married filing jointly – and both you and your spouse cannot contribute to an employer sponsored retirement plan (such as a 401k): No income limit

Please keep in mind that some of these numbers (such as earned income limitations and contribution restrictions) may vary on a yearly basis due to factors such as inflation. 

So if you are reading this article two years from 2020, it would be worth checking out the numbers and figures with your accountant just to make sure that these numbers are still in fact accurate. 

Then again, if there is an update in these numbers and figures, I’ll be sure to blog about it when these updates do in fact occur. Stay tuned!

Final thoughts


Personally, I have everything invested in Roth Accounts. 

I know that I will be in a higher tax bracket in my later earning years

(at least I certainly hope I will be!)

so I want to take advantage of the lower tax bracket I am in currently NOW so that the money invested in my Roth accounts will not be taxable in future years. 

Overall, it’s a general rule of thumb to invest in Roth accounts when you are younger and if you assume you will be in a higher tax bracket down the road. 

Another thing to consider is whether Roth accounts may be around for much longer… 

Because it’s no secret that tax brackets are at almost historic lows in 2020 and that the government carries a lot of debt, one of the ways to lower this deficit is to increase taxes

(so the government can use taxpayer money to lower its deficit). 

A major assumption here is that tax rates will be much higher in future years and that Uncle Sam may actually want all money invested and contributed to retirement accounts to be taxable. 

What if Roth accounts are phased out entirely because (in my humble opinion) they are the best thing since sliced bread!

I don’t know if my fear will ever hold ground, but if it does, my Roth accounts could be grandfathered into the new era. 

Let’s hope it doesn’t come to that point, but it could certainly be a possibility with the country’s rising deficit.

The big picture:

Stop waiting and invest NOW! It’s never too late to save. Your investment accounts will thank me later!

Which account did you choose to open, Roth IRA or Traditional IRA? And why?

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Fiona Smith
Fiona Smith
The Millennial Money Woman was founded by Fiona Smith. She holds her Master of Science Degree in Personal Financial Planning and has co-founded a local non-profit community teaching financial literacy to young professionals.

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