IRA vs Roth IRA: Key Differences and Tax Benefits Explained

Retirement planning is a crucial part of financial security, and choosing the right Individual Retirement Account (IRA) can significantly impact your future. Two common options are the traditional IRA and Roth IRA, each with unique benefits and considerations. Understanding these differences is key to making informed decisions tailored to your long-term goals.

Eligibility Criteria

Eligibility for an Individual Retirement Account (IRA) or a Roth IRA depends on factors like age and income. For traditional IRAs, there is no longer an age limit for contributions as of 2024. However, whether you can deduct contributions on your tax return depends on your income and whether you or your spouse are covered by a workplace retirement plan. For example, single filers covered by a workplace plan see a deduction phase-out starting at a modified adjusted gross income (MAGI) of $73,000 and ending at $83,000.

Roth IRAs base eligibility primarily on income. Contributions are not tax-deductible, but income thresholds are critical. In 2024, single filers can contribute fully if their MAGI is below $153,000, with a phase-out up to $168,000. For married couples filing jointly, the full contribution is allowed if their MAGI is under $228,000, with a phase-out up to $243,000. These limits adjust annually for inflation, so staying updated with IRS guidelines is essential.

Contribution Details

The contribution limits for traditional and Roth IRAs are identical, with a maximum annual limit of $6,500 for 2024 and an additional $1,000 catch-up contribution for those aged 50 and older. This allows older individuals to enhance their retirement savings.

Contributions to a traditional IRA may lower your taxable income in the year they are made, providing an immediate tax advantage. For instance, someone in the 24% tax bracket could save $1,560 in taxes by contributing the full $6,500. However, withdrawals in retirement are taxed as ordinary income.

Roth IRA contributions, made with after-tax dollars, do not offer an upfront tax deduction. However, the potential for tax-free growth and withdrawals in retirement is a significant benefit, especially for those expecting to be in a higher tax bracket in the future. Additionally, Roth IRA contributions can be withdrawn at any time without penalties, offering flexibility.

Tax Treatment

The tax treatment of traditional IRAs and Roth IRAs differs significantly. Traditional IRA contributions are made pre-tax, reducing taxable income in the contribution year. However, withdrawals in retirement are taxed as ordinary income.

Roth IRAs, on the other hand, are funded with after-tax dollars, so there is no immediate tax break. The primary advantage lies in tax-free growth and withdrawals, provided the account has been open for at least five years and the account holder is at least 59½. This tax-free feature can be particularly beneficial for those anticipating higher future tax rates or seeking to avoid required minimum distributions (RMDs), which apply to traditional IRAs starting at age 73.

A strategic option for some is converting a traditional IRA to a Roth IRA, known as a “Roth conversion.” This involves paying taxes on the converted amount but can be advantageous if future tax rates are expected to rise. The Tax Cuts and Jobs Act of 2017, which lowered income tax rates, has made such conversions more appealing by reducing the immediate tax impact.

Distribution Requirements

Distribution rules vary between traditional and Roth IRAs. For traditional IRAs, penalty-free withdrawals can begin at age 59½, though early withdrawals may incur a 10% penalty unless exceptions, such as for qualified education expenses, apply.

Roth IRAs offer greater flexibility. Contributions can be withdrawn at any time without penalties or taxes since they are made with after-tax dollars. Earnings, however, are subject to a five-year holding requirement and must meet age or qualifying event criteria to be withdrawn tax-free.

Inheritance Provisions

Inheritance rules for traditional and Roth IRAs differ in ways that affect how beneficiaries handle inherited accounts. For traditional IRAs, most non-spouse beneficiaries must follow the 10-year rule, introduced by the SECURE Act of 2019, which requires the entire account balance to be distributed within 10 years of the original owner’s death. Spousal beneficiaries have more options, such as rolling the account into their own IRA or treating it as an inherited IRA, which can delay distributions and extend tax-deferred growth.

Roth IRAs provide a tax-efficient advantage for beneficiaries. While the 10-year rule also applies to non-spouse beneficiaries, distributions are tax-free as long as the account has met the five-year holding requirement. Spousal beneficiaries can roll the account into their own Roth IRA, ensuring continued tax-free growth without being subject to RMDs. This feature makes Roth IRAs particularly appealing for those focused on leaving a tax-efficient legacy.