Distinguishing Between Roth IRA and Traditional IRA: A Comprehensive Comparison

The Roth IRA vs traditional IRA – they’re basically the same plan, right?

Not exactly.

While they do share some similarities, there are enough distinct differences between the two where they can just as easily qualify as completely separate and distinct retirement plans.

To clear up the confusion between the two, let’s look at where Roth IRAs and traditional IRAs are similar, and where they’re different.

Roth IRA vs Traditional IRA – Where They’re Similar

Roth IRA vs traditional IRA – they’re similar only in the most basic ways. This is what often leads to confusion between the two plans, and even a lack of awareness of the very specific benefits of each.

Plan Eligibility

Virtually anyone can contribute to an IRA, Roth or traditional. The most basic requirement is that you have earned income.

Earned income is from salary and wages, contract work, or self-employment.

Unearned income – such as interest and dividends, pensions and Social Security, capital gains and rental income – are not eligible income sources.

Even your kids can make contributions to either a Roth or traditional IRA. Though they can’t legally own an account, an IRA can be set up as a custodial account.

The account is in the name of the minor but is technically owned and managed by a parent or guardian. Upon reaching the age of majority – 18 or 21, depending on your state – ownership of the account transfers to the minor.

Either plan is an excellent choice, particularly if you’re not covered by an employer-sponsored retirement plan. It’s also the most basic type of retirement plan, which makes it very easy to open and manage.

In the normal course, you don’t even need to file any additional tax or reporting documents with the IRS.

One minor difference between traditional and Roth IRA’s used to be that you couldn’t make contributions to traditional IRAs after age 70 1/2, though you could still contribute to a Roth IRA. But that distinction was eliminated for tax years beginning in 2020 and beyond.

You can now contribute to either a traditional or Roth IRA at any age, as long as you have earned income.

With both IRAs, the IRS has announced some 2023 changes that could benefit you.

Roth and Traditional IRA Contribution Limits

The two plans have identical contribution limits.For 2023, IRS regulations allow you to make an annual contribution of $6,500. If you’re age 50 or older, there is a “catch-up contribution” of $1,000 per year, in which case your total contribution will be $7,500 per year.

There’s a secondary contribution limit that doesn’t apply to most taxpayers. However, it could affect high income taxpayers who are covered by an employer plan.

Contribution Year49 and Under50 and Over (Catch Up)

The maximum contribution to all retirement plans in 2023 is $66.000, and $63,500 if you’re 50 or older.

That includes contributions to an employer-sponsored 401(k), 403(b), 457 plan, or the federal government TSP plan. It also includes contributions made to self-employment plans, such as a Solo 401(k), or a SEP or SIMPLE IRA.

The combination of your contributions – including employer matching contributions – to any of these plans, including an IRA, can’t exceed these thresholds.

If you’re participating in either an employer-sponsored plan or a self-employment plan, with contributions totaling $54,000, your IRA contribution will be limited to $3,000 ($57,000 less $54,000). If your total contributions reach $57,000 with the other plans, you won’t be able to make an IRA contribution at all.

Tax-deferral of Investment Earnings

Both a Roth IRA and a traditional IRA enable your funds to accumulate investment income on a tax-deferred basis.This is a powerful investment advantage since it enables you to invest without regard for tax consequences. It means you get the full benefit of investment earnings, and the extra compounding they provide.

Even if your contributions are not tax-deductible, the investment income earned will still be tax-deferred. This is the kind of advantage that can result in a 10% return on investment in an IRA account, compared to say, 7.5% in a taxable account (assuming a 25% tax rate).

Now if you’re already familiar with how a Roth IRA works, you’re probably thinking he’s wrong, Roth IRA investment income isn’t tax-deferred, it’s tax-free – he’s wrong! That’s partially true, and we’ll get to that in a little bit.

But technically speaking, Roth IRA investment earnings are also only tax-deferred.

You must be at least 59 1/2 years old, and have been in the plan for at least five years to be able to withdraw investment earnings tax-free.

If you withdraw money sooner, investment income will be fully taxable. So yeah, Roth IRA investment income is also tax-deferred, at least during the accumulation phase.

Investment Options

This is one of the biggest advantages to IRA plans, both Roth and traditional. As the owner of an IRA account, you’re free to invest anyway you like. You can choose the trustee, which can include any of the following:

  • Banks
  • Investment brokers
  • Mutual fund companies
  • Professionally managed accounts
  • Robo-advisors

In fact, just about anywhere that you can invest money, you can set up an IRA account.

For example, peer-to-peer lending platforms, like Prosper allow IRA accounts. You can invest in personal loans through an IRA by doing this. You can also invest in online real estate crowd-funding platforms in your IRA using companies like Fundrise.

Within many of these accounts, you also have nearly unlimited investment options. This includes stocks, bonds, mutual funds, exchange-traded funds (ETFs), futures and options, commodities, government securities and real estate investment trusts (REITs).

The IRS has a very short list of prohibited IRA investments. Those include:

  • Artwork,
  • Rugs,
  • Antiques,
  • Metals – with exceptions for certain kinds of bullion,
  • Gems,
  • Stamps,
  • Coins – (but there are exceptions for certain coins),
  • Alcoholic beverages, and
  • Certain other tangible personal property.

Virtually everything else is fair game! And it makes no difference if it’s a Roth or traditional IRA.

Early Withdrawal Rules – Basically the Same

This is where the comparison between the Roth IRA vs traditional IRA gets a bit technical.Both plans provide for eligible withdrawals beginning at age 59 1/2. If you take withdrawals sooner, they’ll be subject to ordinary income tax in the year of withdrawal, plus a 10% early withdrawal penalty tax.

Roth IRA vs Traditional IRA difference: There’s an exception here with the Roth IRA. Income tax and the penalty will only apply to the amount of investment earnings withdrawn before turning 59 1/2. The contributions themselves will not be taxable, nor will they be subject to a penalty.

There are exceptions to the early withdrawal penalty, but not ordinary income tax.

Even if an early withdrawal qualifies for an exception, you will still have to pay ordinary income tax on the amount of the withdrawal. Only the penalty is waived.

The IRS has a list of exceptions to the early withdrawal penalty. Two of the more common exceptions are qualified education expenses, and up to $10,000 toward a first-time home purchase.

Roth IRA vs Traditional IRA – Where They’re Different

So far, we’ve covered how the Roth IRA and traditional IRA are similar. Now let’s move on to where they’re different. And in many cases – very different!

Tax Deductibility of Contributions

We don’t need to spend a lot of time on this one. The difference here simple:

  • Contributions to a traditional IRA are usually deductible.
  • Contributions to a Roth IRA are never deductible.

The one wrinkle in a simple formula is the word usually with the traditional IRA.

Contributions are fully deductible if neither you nor your spouse are covered by an employer-sponsored retirement plan. But if one or both are, then the contributions are either non-deductible, or only partially deductible.

Which leads nicely into the next difference…

Income Limits for IRA Contributions

The IRS has income limits, beyond which you’re not eligible to make a Roth IRA contribution at all.

The income limits for 2023 for Roth IRA contributions are as follows, and based on adjusted gross income (AGI):

  • Married filing jointly, permitted to $218,000, phased out to $228,000, then no contribution permitted.
  • Married filing separately, phased out to $10,000, then no contribution permitted.
  • Single, head of household, or married filing separately and you did not live with your spouse at any time during the year, permitted to $138,000, phased out to $153,000, then no contribution permitted.

The income limits for traditional IRAs are loosely similar, but work very differently. There are two sets of income limits.

The first applies if you’re covered by a retirement plan at work. It’s based on modified adjusted gross income, or MAGI. It looks like this for 2023:

  • Single or head of household, fully deductible up to $73,000, partially deductible to $83,000, then no deduction permitted.
  • Married filing jointly or qualifying widower, fully deductible up to $1116,000, partially deductible to $136,000, then no deduction permitted.
  • Married filing separately, partially deductible up to $10,000, then no deduction permitted.

There’s a second set of income limits, also based on MAGI, if you’re not covered by an employer plan, but your spouse is:

  • Married filing jointly, fully deductible up to $218,000, phased out up to $228,000, then no deduction permitted.
  • Married filing separately, partial deduction up to $10,000, then no deduction permitted.

If you exceed the income limits, you can still make a non-deductible traditional IRA contribution.

Income Limits for Roth IRAs

Roth IRAs have a different set of income limitations. They are as follows for 2023:

  • Married filing jointly, fully deductible up to $196,000, partially deductible up to $206,000, then no deduction permitted.
  • Married filing separately, fully deductible up to $10,000, then no deduction permitted.
  • Single or head of household, fully deductible up to $124,000, partially deductible up to $139,000, then no deduction permitted.

One of the major differences between traditional and Roth IRAs is that once you reach the income threshold for a Roth IRA, no contribution is permitted at all.

No contribution is permitted for a Roth IRA if you exceed the income limits.

If you make too much money, the Roth IRA is not an option

Taxability of Non-deductible Contributions

Roth IRA contributions are not tax-deductible, so withdrawals are not taxable. This works neatly within IRS ordering rules. This applies specifically to Roth IRAs, and it enables you to make withdrawals based on the following priority:

  1. IRA participant contributions
  2. Taxable conversions
  3. Non-taxable conversions
  4. Investment earnings

This means the first withdrawals made from a Roth IRA are considered contributions and are therefore not taxable upon withdrawal.

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