Saving for retirement should be a straightforward concept: by setting aside a portion of your income now and living within your means, you pave the way for a comfortable retirement using your accumulated savings.

While workplace retirement plans like 401(k)s or 403(b)s often facilitate this process, there are instances where you need to explore retirement saving alternatives outside of your workplace. This is where the choice between a traditional IRA and a Roth IRA comes into play.

Both account options offer superior financial and retirement planning benefits compared to not saving at all. Understanding the optimal usage scenarios for each account can yield advantages both now and in your future.

Similarities between Traditional IRA and Roth IRA

Qualified Retirement Plans

A traditional IRA and a Roth IRA are both qualified retirement plans. This status entitles them to specific tax benefits as outlined by the IRS tax code for retirement plans.

In either case, your contributions and the resulting investment income, including dividends and growth, accumulate without immediate taxation.

Contribution Limits

Contributions to IRAs are subject to annual limits defined by the IRS. In 2023, the maximum contribution is $6,500, limited to your earned income.

Contributing to an IRA hinges on earning income; unearned sources like rental income or Social Security don’t count. An exception exists for non-earning spouses in joint tax returns, such as stay-at-home parents, who can contribute to a spousal IRA up to the same limits.

For those aged 50 or above, an additional catch-up provision permits an extra $1,000 per year contribution, catering to increased savings during peak earning years nearing retirement.

You can make IRA contributions for a given tax year until the tax filing deadline.

Withdrawal Limitations and Penalties

As vehicles for retirement savings, IRAs impose penalties for early withdrawals (before age 59 ½).

The penalty is a 10% fee on the distribution, with exceptions for specific cases like medical expenses, disability or higher education.

While Roth IRAs have nuanced withdrawal rules (five-year rule, withdrawal of basis, etc.), their purpose is clear: income in retirement. The IRS wants you to wait until retirement to withdraw from the accounts. Premature withdrawals are typically discouraged and penalized.

Differences in Taxation: Traditional IRA vs. Roth IRA 

Traditional IRA

Contributing to a traditional IRA lowers your current taxable income, provided your income falls within certain limits based on your tax status. In essence, your contribution amount reduces your taxable income for the present year.

Additionally, the account’s growth due to market gains and dividends isn’t subject to current-year taxes (tax deferment).

This means that not a single dollar within the traditional IRA has been taxed. Conversely, withdrawals during retirement are 100% taxable, much like the taxation you experienced while working.

Roth IRA

Contributions to a Roth IRA use “after-tax” funds, entailing no immediate tax deduction; taxes are paid on the contributed amount.

As with the traditional IRA, growth in the account remains untaxed. However, the appeal of the Roth lies in its tax-free withdrawals during retirement.

Since you paid taxes when contributing, subsequent growth remains tax-exempt.

How to Choose the Right Retirement Account

While several financial planning factors influence retirement funding decisions, the crux of the IRA choice revolves around this question: “Should I leverage a current tax deduction via a traditional IRA or pay more taxes now for tax-free retirement income (Roth IRA)?”

Individual circumstances vary, and tax considerations fluctuate annually, so there isn’t a universal answer. Nonetheless, comprehending the key attributes of each account empowers more informed decisions in preparing for retirement.Our fiduciary financial planning firm in Spokane, Washington, collaborates with clients to tailor account types and amounts to their financial circumstances and retirement objectives. Schedule a no-cost insight meeting to explore your situation and how our assistance may prove valuable.