An Individual Retirement Account (IRA) is one of two primary types of tax-advantaged retirement accounts, which are meant to incentivize saving for retirement. The other type is a 401(k), which is an account that must be sponsored by an employer. IRAs are available to everyone, regardless of employment status.
Under the IRA umbrella, there are two preliminary types of accounts: the traditional and the Roth. Both are subject to the same annual contribution limits and early withdrawal penalties. But they have different eligibility requirements and tax advantages.
Two types of IRAs: Traditional and Roth
- Traditional IRAs are tax-deferred retirement accounts that are available to everyone with earned income. They let investors contribute money toward retirement with pretax income, which means they don’t have to pay taxes on eligible contributions in the year they make them. So if they contribute, say, $1,000 in 2021, they can reduce their taxable income by that same amount when they file their federal tax returns for that year. The funds are subject to taxes when they take distributions from their account in retirement, when they’re at least 59½ years old.
- Roth IRAs are tax-exempt retirement accounts that are available to eligible participants based on income. They allow investors to contribute money after they’ve paid tax on it, not before. That means they pay income tax on contributions when they’re made, but not when they’re withdrawn in retirement.
Here’s a detailed breakdown of the differences between traditional and Roth IRAs.
1. Tax advantages
Traditional and Roth IRAs both have tax advantages, but of different natures. A traditional IRA allows investors to deduct eligible contributions from taxable income when they contribute, but they must pay income tax on their withdrawals in retirement. A Roth IRA doesn’t offer a tax deduction on contributions, but all earnings are tax-free when they’re withdrawn in retirement.
2. Eligibility requirements, income limits, and phase-out limits
Anyone with earned income can contribute to a traditional IRA, but only those who meet the income limits can contribute to a Roth. There are income limits on the tax deduction for a traditional IRA if investors also have access to a workplace retirement plan like a 401(k).
There are no income limits for contributing to a traditional IRA, but investors’ tax deduction may be reduced or eliminated if they’re also covered by an employer-sponsored retirement plan. If investors are covered by a workplace retirement plan and their annual modified AGI (annual gross income) falls within these ranges, they’ll receive a reduced tax deduction on their traditional IRA contributions:
- Single taxpayers: $66,000 to $76,000
- Married filing jointly: $105,000 to $125,000
- Not covered by workplace plan, but married to someone who is: $198,000 to $208,000
If investors’ income is above the top end of the range and they’re covered by a workplace retirement plan, they won’t receive any tax deduction on their IRA contributions.
In addition to having earned income, investors must meet the income limits to open and contribute to a Roth IRA.
- Single taxpayers: less than $125,000 for maximum contribution
- Married filing jointly: less than $198,000 for maximum contribution
Investors may still qualify to make smaller contributions if their income is less than $140,000 for single filers and less than $208,000 for married taxpayers filing jointly.
3. Required minimum distributions
Traditional IRAs come with required minimum distributions (RMDs). Once investors reach age 72, they are required to withdraw funds each year (and consequently, pay taxes on them). They may withdraw more than the RMD.
Since investors don’t have to pay taxes on their Roth IRA withdrawals, the government does not require them to take mandatory distributions at any time. With a traditional IRA, however, they must begin taking withdrawals once they reach age 72.
Contribution limits for traditional and Roth IRAs
The maximum contribution limit in 2021 for both traditional and Roth IRAs is either 100% of earned income, or $6,000, whichever is less. Investors may contribute an additional $1,000 each year (for a total of $7,000) once they reach 50 years old.
Note that these are combined limits across traditional and Roth IRAs. If investors make the maximum contribution to a Roth IRA, they may not invest another $6,000 in their traditional IRA. The $6,000 limit applies to the sum of their contributions to traditional and Roth IRAs.
The bottom line
Both traditional and Roth IRA accounts are subject to the same annual contribution limits and early withdrawal penalties. However, it’s important to note they have different eligibility requirements and tax advantages.