Which IRA Is Better for Taxes? Traditional IRA vs. Roth IRA

The federal government uses tax policy to encourage people to save money. You can use those incentives to your advantage, but it is also important to understand they typically come with strings attached.

Traditional and Roth IRAs have different tax advantages and are subject to different limitations. Here are some of the key tax features of each type of account.

Traditional IRAs

A traditional IRA carries two forms of tax advantage: There is an immediate tax deduction when you contribute money, and any investment earnings, including interest and gains, are not taxed for as long as they are in the account.

However, there are limitations. According to IRS rules, you can only contribute up to $6,000 per year (or $7,000 if you are 50 or older), and there is a 10% penalty if you take money out of a traditional IRA before age 59 1/2.

More Limitations for High Earners

The amount you can deduct may be even more limited if you are a high earner or if a retirement plan at work covers you.

Beyond those limitations, what can be easy to overlook about the initial tax advantages of traditional IRAs over Roth IRAs is that they are essentially temporary.

When you eventually withdraw money from a traditional IRA, it is taxed as ordinary income, and you are required to begin withdrawing money from an IRA once you reach age 70 1/2.

So, a traditional IRA does not eliminate taxes on your contributions and your investment earnings, but it does put them off. The premise is that people are likely to be in a higher tax bracket in their peak earning years, so an IRA allows them to put off taxation until retirement when their income will be more limited and thus place them in a lower tax bracket. However, given the uncertainty of changes in tax rates, that benefit is by no means certain.

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Roth IRAs

Unlike contributions to traditional IRAs, contributions to traditional IRAs are not tax deductible. However, distributions from Roth IRAs are not taxable as long as you are at least 59 1/2 years old and the IRA has been set up for at least five years.

Avoid Paying Taxes on Money Earned

So, while there is less tax benefit on the front end, a Roth IRA does allow you to avoid paying taxes on money earned within the account. Therefore, the younger you are, the greater the tax advantage of a Roth IRA since you will have more time to accumulate investment earnings and thus benefit from avoiding taxes on those earnings.

Taxation can be a somewhat emotional issue. People often resent having to give back part of what they have earned, which is one reason why tax breaks have such a strong appeal. The key is to realize that there is generally some form of commitment required in order to take advantage of these breaks, and it is that long-term commitment that you have to weigh against the short-term tax benefit.

Though tax breaks are designed to encourage Americans to raise their savings rates, in the end, those tax breaks are somewhat limited. Thus providing for a comfortable retirement should be your primary motivation to save, rather than tax avoidance.

At What Age Are You Required to Take Out the Remaining Money in an IRA?

Technically, the answer is never, though traditional IRAs are designed to be drawn down substantially over your remaining lifetime. Roth IRAs, on the other hand, have no required schedule for taking money out of the plan.

Required Minimum Distribution Schedule

Traditional IRAs are subject to required minimum distributions (RMDs), which dictate which portion of your remaining IRA balance must be withdrawn each year. RMDs start in the year you turn age 70 1/2.

The portion of your IRA you are expected to withdraw is determined by your expected remaining lifespan, which naturally gets shorter over time. To make sure you are able to preserve some IRA assets even if you live an extraordinarily long life, the IRS never requires you to withdraw all of the remaining assets in your IRA.

When You Have a Younger Spouse

There is a different schedule for RMDs if you have a spouse who is 10 or more years younger than you and is the sole beneficiary of the IRA. In this case, the schedule is based on a blend of your age and your spouse’s age, which slows down the pace of RMDs. This allows you to preserve more of the IRA for your spouse’s future benefit on the assumption that a significantly younger spouse is likely to outlive you.

Impact on Your IRA Balance

Some specific examples can help illustrate how this works. These illustrations are based on an IRA owner who does not have a spouse who is ten or more years younger.

In the year you turn 70 1/2, you still may have a fairly long remaining lifespan, so the RMD schedule at that age is based on distributing your remaining IRA assets over a period of 27.4 years. Thus your RMD for that first year would be your remaining IRA balance divided by 27.4.

This would result in an RMD of about 3.6 percent of your IRA’s value. That wouldn’t deplete your plan much, and with decent investment results, you could easily make that back over the next year. However, as you grow older and your assumed remaining lifespan shortens, the pace of RMDs picks up.

When you are 80, the RMD schedule is based on distributing your remaining IRA assets over a period of 18.7 years. This means your RMD that year would represent about 5.3 percent of your IRA balance. Should you live to be 90, the RMD schedule is based on distributing your remaining IRA assets over a period of 11.4 years, which means your annual RMD at that point would represent about 8.8 percent of your IRA balance.

The schedule continues in this manner: as you get older, the distribution period gets shorter, making each distribution a larger portion of your remaining assets. However, the shortest the distribution period ever gets (applicable at age 115 and beyond) is 1.9 years. This means you are never required to withdraw more than about 52.6 percent of your remaining balance.

Implications for Retirement Planning

You’ve worked all your life to save enough for retirement and now need to work at carefully managing withdrawals. Because of the changing pace of RMDs and the fact that they are likely to draw your IRA balance down over time, your RMD amounts may not coincide with your financial needs in any given year.

For this reason, it is wise to preserve some of the money from RMDs outside of the IRA in case your future spending needs exceed your RMD amounts in later years.

Tax Implications of a Traditional IRA vs. Roth IRA

The age of 59 1/2 is the time you should be making decisions about using money from an IRA. Normally, IRA distributions before that age would require you to pay a 10% penalty for taking the money out early. However, there is an exemption of $10,000 for first-time home buyers. So, if this is your first time buying a home, you may be able to use $10,000 from your IRA toward it without penalty.

The next thing to consider is whether the money you take out of the IRA will be impacted by ordinary income taxes. Here, the key consideration is whether the IRA is a traditional or a Roth IRA.

With a traditional IRA, the contributions you make to the account are tax-deductible, so money is taxed when you take it out.

With a Roth IRA, though, you will have paid taxes already on money going into the account. As a result, distributions would not be subject to ordinary income taxes if you have had the IRA for at least five years. However, the $10,000 home buyer exemption also applies in this situation, so you should be in the clear if that is the case.

Home Equity vs. Retirement Savings

Taking money out of an IRA before age 59 1/2 to pay for a home substitutes one form of wealth for another — you would be gaining some home equity and losing some retirement savings. Be sure to consider the long-term implications of this switch, both in terms of keeping up with mortgage payments and retirement planning.

Obviously, the $10,000 IRA early withdrawal exemption you might be able to put toward a house would help with the down payment, but this would still leave you with a mortgage to pay.

You need to look at what the mortgage payment schedule would be and how this would fit within your budget. Longer-term, this would mean $10,000 less in retirement savings. Going forward, can your plan of saving for retirement make up for that reduction? Keep in mind that home equity won’t necessarily help you pay your monthly bills, now or in the future.