Roth Or Traditional IRA, Which One Should You Use?

An individual retirement account (IRA) is an excellent tool for accumulating a sizable nest egg. You may amass a portfolio worth hundreds of thousands of dollars if you contribute consistently and diversify your investments. However, there are two types of IRAs: standard IRAs and Roth IRAs.

Which account is a better choice for your retirement? This is a challenging decision. Even experienced financial advisors may need help answering this question. However, there are some essential variables to consider, and they all revolve around the tax consequences.

To further grasp this, consider the similarities and differences between traditional and Roth IRAs.

The Similarities

The contribution maximum for regular and Roth IRAs in 2023 is $6,500. If you are 50 or older, you can increase your donation limit to $7,500 in 2023. You usually have until the tax deadline the following year to contribute for any given tax year. As a result, most people have until Tax Day 2024 to contribute to their IRAs for the 2023 tax year. There are no age restrictions.

The contribution amount must come from your earned income, such as earnings, salary, commissions, tips, bonuses, or self-employment profits. This excludes earnings from rental properties, annuities, pensions, and deferred compensation. If one spouse does not work, the earned income of the other spouse may be used to start a separate IRA in their name, known as a "spousal IRA," as long as the couple files a joint federal tax return.

Let's look at some of the critical distinctions now. They include whether or not you can deduct contributions and whether or not dividends are tax-free.

The Tax Reductions

The IRS forbids taxpayers from deducting Roth IRA contributions. Contributions to a regular IRA, on the other hand, may be tax deductible.

Assume you are 55 years old and file as single. You need to catch up to your retirement goals, so you decide to contribute the maximum amount to your IRA account. This consists of $6,500 + a $1,000 catch-up payment of $7,500. You are in the 24% federal tax bracket based on your current salary. This translates to a deduction of 24% multiplied by $7,500, or $1,800. You can also be eligible for a state tax break.

But there's a catch. If you or your spouse is eligible for an employer-sponsored retirement plan such as a 401(k) or 403(b), you may be unable to claim the full deduction for your typical IRA contribution. Your contribution amount will be tapered based on your modified adjusted gross income (MAGI). The IRS establishes the restrictions each year.

Distributions

The IRS places restrictions on the distribution of funds from regular IRAs. If you withdraw before the age of 59 and a half, you will be subject to income taxes and a 10% penalty. The penalty includes several exceptions, such as total and permanent incapacity, $10,000 for a qualified first-time home purchase, and some unreimbursed medical expenses.

The penalty is also waived when you reach the age of 59 and a half. However, you are still required to pay income taxes.

There are fewer withdrawal restrictions with a Roth IRA. You can withdraw your payments tax-free and penalty-free at any time. However, to be eligible for earnings in the account, you must be 59 and a half and have held the Roth IRA for at least five years.

For example, you are 58, single, and pay 24% in taxes. You opened a Roth IRA two years ago and have contributed $20,000, with profits of $5,000. You can withdraw the $20,000 without incurring any taxes or penalties. However, this is different from your earnings. You'll have to pay $1,200 in taxes (24% multiplied by $5,000) plus a $500 penalty (or 10% multiplied by $5,000).

Which One Is Right For You?

Choosing between a standard IRA and a Roth IRA boils down to considering various possibilities. For example, if you are now in your prime earning years and feel your retirement income will be smaller, consider a traditional IRA. Your payouts will be taxed at a lower rate as a result.

On the other hand, if you are young and just starting out in your profession, a Roth may be a better alternative. The tax benefits of typical IRA deductions may be less appealing.

To have a better understanding of what's the best option for you, let's schedule a quick call so we can talk about your plans, future, and goals. This conundrum can be easily solved with a clearer perspective of what you want to achieve.

This material has been prepared solely for informational purposes and is not intended to provide, nor should it be relied on for, tax, legal, or accounting advice. Accordingly, before entering any transaction, you should consult with your tax, legal, and accounting advisors.