Roth vs Traditional IRAs: A Complete Reference Guide

First off, congratulations for thinking about retirement and taking the time to learn about it. Second, Sorry! I know this can be a dry topic. I’ve tried to provide all the information I can about Roth and Traditional IRAs, so that you can get started using them.

If you are having trouble finding money to invest in an IRA, Try creating a monthly budget. My preferred budget type is the zero-based budget. You can learn how to create your own by reading How to Create your own Zero-Based Budget.

Now, time to start learning bout Roth and Traditional IRAs

The term “IRA” may seem like jargon right now (It is!), but by the end you’ll have a full understanding of what they are and how opening an IRA will help you keep more of your hard-earned money. Let’s take a few minutes to study about saving for retirement using the two most common types of IRAs.

Roth vs Traditional IRAs: Quick Difference Summary

What is an IRA?

According to the IRS, IRA stands for “Individual Retirement Arrangement”, however, you’ll commonly here people refer to it as an “Individual Retirement Account”.

IRAs came to exist as a result of the Employee Retirement Income Security Act (ERISA) of 1974. This created what we call today the Traditional IRA. With a Traditional IRA, pre-tax money is used to invest and the taxes are taken when you withdrawal the money.

Initially, IRAs could only be invested into a special US bond, certain or a trust maintained by a bank or an insurance company. Today, the IRS Code only has restrictions on what is not allowed inside an IRA. A lot of those restrictions are in place to prevent the account holder from immediately benefiting from the money.

That said, most financial institutions limit available investments to traditional brokerage accounts such as stocks, bonds, and mutual funds. Think Vanguard, Charles Schwab, or whoever your favorite brokerage is. These are the places that come to mind when you think about retirement accounts.

Roth IRA History

Roth IRAs were introduced in 1997 with the Tax Payer Relief Act. They were originally called an “IRA Plus”, but have since been named after the senator William Roth, who introduced the idea.

With a Roth IRA, after-tax money is used to invest and the no taxes are taken when you withdrawal the money.

Why invest in an IRA?

Here are some quick points on why an IRA is good, before we dig down into the nitty gritty rules and details.

Tax Breaks

Tax Breaks are the main reason to use an IRA. Another term commonly use is tax-advantaged accounts. Depending which IRA you use, you will either save on taxes now, by means of a tax deduction, or you will save on taxes later with tax-free withdrawals.

More Investment Options

An IRA allows a wider range of investment options than what is typically offered through a 401(k), or other employee sponsored plans

Should I contribute to a Roth IRA or Traditional IRA?

This is the key question. Does it make more financial sense to have tax-free withdrawals in the future or is it better to contribute tax free this year? The answer to the question lies in what your tax bracket is now vs. what you estimate it will be when it comes time to withdrawal from the IRA. In short, a Traditional IRA is better if you think you will have a lower tax rate in retirement. A Roth IRA is better if you think you will have the same or higher tax rate. This assumes you are withdrawing after the age 59 ½. Bankrate offers a great calculator for helping you determine which type of IRA is better.

The Nitty Gritty Details

Contribution Limits for 2020

$6,000 total contribution
$7,000 total contribution, for people ages 50 and older

P.S. – They are the same as they were for 2019.

Contribution Rules

IRA Eligibility

Age

Traditional: You can contribute to a Traditional IRA until age 70 ½. Once you pass age 70 ½, you must start taking RMDs (Covered Later in Withdrawal Rules).

Roth: You can contribute to a Roth IRA an any age

Income

Traditional: Your income must exceed the amount you contribute.

Roth: Your income must exceed the amount you contribute AND your income must be under a certain limit, which is set by the IRS. The limits are set by the IRS every year and are released towards the end of the preceding tax year. For example, the 2020 limits were released in October 2019.

Here is the table direct from the IRS explaining those limits:

If your filing status is…	And your modified AGI is…	Then you can contribute…
married filing jointly or qualifying widow(er)	< $193,000	up to the limit
	> $193,000 but < $203,000	a reduced amount
	> $203,000	zero
married filing separately and you lived with your spouse at any time during the year	< $10,000	a reduced amount
	> $10,000	zero
single, head of household, or married filing separately and you did not live with your spouse at any time during the year	< $122,000	up to the limit
	> $122,000 but < $137,000	a reduced amount
	> $137,000	zero

*Note: 2020 Contributions limits have been released and are the same as the 2019 limits. The IRS just hasn’t updated their table yet.

Special Income Rules

Non-Working Spouses: If you have a spouse, and they do not work, they can make contributions based on your income. This is a cool exception to the rules. It’s the only time a person who doesn’t work can make IRA contributions! These are called “spousal IRAs.” The total amount contributed by both spouses can’t exceed the amount of income earned by the working spouse or the IRS limits.

For example, let’s say you are married and have a spouse who stays at home with the kids. You make $50,000 a year and you are both under 50 years old. In 2019, the working spouse can contribute $6,000 to his IRA, and the stay at home spouse can contribute $6,000 to their IRA. That’s a total of $12,000 tax-advantaged dollars!

Children Under 18 (Minors): If your child makes an income, they can contribute to an IRA. The same rules apply! That means your child will have to file tax returns if they or the parent want to make IRA contributions.

Contribution Deadline

IRA contributions must be made by the tax filing deadline. Typically, that is April 15th. If April 15th is a weekend, the filing deadline will be the next business day. Tax-filing extensions do not apply to your Traditional or Roth IRA contributions. The one exception is for SEP-IRA contributions, which is beyond the scope of this article.

Tax Deduction

Traditional:

If you are covered by a retirement plan at work:

If Your Filing Status Is…	And Your Modified AGI Is…	Then You Can Take…
single or head of household	$64,000 or less	a full deduction up to the amount of your contribution limit.
	more than $64,000 but less than $74,000	a partial deduction.
	$74,000 or more	no deduction.
married filing jointly or qualifying widow(er)	$103,000 or less	a full deduction up to the amount of your contribution limit.
	more than $103,000 but less than $123,000	a partial deduction.
	$123,000 or more	no deduction.
married filing separately	less than $10,000	a partial deduction.
married filing separately	$10,000 or more	no deduction.
If you file separately and did not live with your spouse at any time during the year, your IRA deduction is determined under the “Single” filing status.

If you are NOT covered by a retirement plan at work:

If Your Filing Status Is…	And Your Modified AGI Is…	Then You Can Take…
single, head of household, or qualifying widow(er)	any amount	a full deduction up to the amount of your contribution limit.
married filing jointly or separately with a spouse who is not covered by a plan at work	any amount	a full deduction up to the amount of your contribution limit.
married filing jointly with a spouse who is covered by a plan at work	$193,000 or less	a full deduction up to the amount of your contribution limit.
	more than $193,000 but less than $203,000	a partial deduction.
	$203,000 or more	no deduction.
married filing separately with a spouse who is covered by a plan at work	less than $10,000	a partial deduction.
	$10,000 or more	no deduction.
If you file separately and did not live with your spouse at any time during the year, your IRA deduction is determined under the “Single” filing status.

Roth: Roth IRA contributions are made with after-tax dollars. There is no tax deduction for these contributions.

Withdrawal Rules

Taxes on Withdrawals

Traditional: Traditional IRA withdrawals are taxed as regular income. Withdrawals from a tradition IRA before age 59 ½ will result in getting hit with a 10% early withdrawal penalty on top of that. There are some exceptions to this that I review in the next section

Roth: Roth IRA withdrawals are tax free. You already paid taxes on the money before it was put into the account, and now you get to reap the rewards when you take the money out.

Withdrawals from a Roth IRA before age 59 ½ have a few stipulations attached. If you withdraw any of the earnings (That is anything over what you have contributed), you will be hit with the 10% early withdrawal penalty as well as your income tax rate. Of course, there are some exceptions to this. They are described in the next section.

Early Withdrawal Penalty

Exceptions

Traditional:

First-time home buyer, up to $10,000.
Higher education expenses
Medical expenses not covered by insurance
IRS levies on the IRA
Health insurance premiums after you’ve received at least 12 consecutive weeks of unemployment compensation.
A reservist called to active duty for more than 179 days.
The IRA account holder is totally and permanently disabled, per the IRS’s disability rules. (Refer to IRC section 72(t)(2)(a)(iii))
Withdrawals to beneficiaries or estates upon the account holder’s death.

Roth:
You have had the Roth IRA for at least 5 years, and one of the following:

First-time home buyer, up to $10,000.
The IRA account holder is totally and permanently disabled, per the IRS’s disability rules. (Refer to IRC section 72(t)(2)(a)(iii))
Withdrawals to beneficiaries or estates upon the account holder’s death.

Required Minimum Distributions

Traditional: Required minimum distributions, commonly referred to by their abbreviation, RMD’s, start the year after you reach the age ~~70 ½~~. Now age 72 due to the SECURE act passed in December 2019. The first RMD must be taken by April 1st. You have until December 31st for each following year. The size of the distribution is a formula based on your life expectancy and the balance of your IRA. To make things even more fun (aka confusing), the formula also varies based on if you have a spouse and their age in relation to you.

The IRS has a total of three tables for the various RMD situations. To determine which table is applicable to you, visit the IRS link here: IRS – Determine which Table

The actual tables are located in the same publication, but here is a link to make it easy for you: IRS RMD Tables

If you do not take any distributions, or if the distributions are not large enough, you may have to pay a 50% excise tax on the amount not distributed as required. Ouch! Don’t do that.

Roth: Roth IRAs do not have a mandatory distribution or withdrawal at any age. You are free to use the money as you wish.

Conversions & Recharacterizations

Traditional to Roth

Known as a Roth conversation, it is the taking all or part of the balance of an existing traditional IRA and moving it into a Roth IRA. You will have to pay taxes as part of the conversion.

Converting is a one-way street. You can’t convert money in a Roth IRA to a Traditional IRA. You can convert whenever you want, there are no deadlines.

Backdoor Roth

A Roth conversion, as described above, can get you into a Roth IRA—even if your income is too high. The conversion would be part of a 2-step process, often referred to as a “backdoor” strategy. First, place your contribution in a traditional IRA—which has no income limits.

Recharacterizations

A recharacterization moves money from a traditional IRA to a Roth IRA—or vice versa. More specifically, it changes the designation of a specific contribution from one type of IRA to the other. If you recharacterize a contribution as a Roth, you must meet the eligibility requirements.

Your contribution must be recharacterized on or before your tax-filing deadline for the year for which it was made.

Due to the Tax Cuts and Jobs Act of 2017, Roth conversions completed after December 31, 2017, can no longer be recharacterized back to a traditional IRA later.

Rollovers

A rollover is when you move the assets in an employer-sponsored retirement plan, such as a 401(k) or 403(b), into an IRA. With an IRA rollover, you can preserve the tax-deferred status of your retirement assets, without paying current taxes or early withdrawal penalties at the time of transfer.

Most rollovers occur when people change jobs. Rollover IRAs can be moved to a new employer’s retirement plan.

Other types of IRAs

These plans are directed at small businesses.

SIMPLE IRA

SIMPLE is an acronym for Savings Incentive Match Plan for Employees. The IRS describes them as ways an employer can provide “a simplified method to make contributions toward their employees’ retirement and their own retirement. Contributions are made directly to an IRA, set up for each employee (a SEP-IRA).”

SEP

SEP is an acronym for Simplified Employee Pension plan. The IRS describes them as means “small employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or nonelective contributions. All contributions are made directly to an IRA set up for each employee (a SIMPLE-IRA).”

IRS Publications

The IRS does provide helpful publication. They may be lengthy and slightly hard to find information quickly though.

Terminology

I’m avoiding using some IRS terminology here because they can make things more confusing, but here they are for completeness sake.

Basis: The funds in an IRA that already have been taxed, either as nondeductible IRA contributions or after-tax funds rolled over from plans. Roth IRA contributions and Roth conversions are all basis since those funds have already been taxed.

Custodian: The financial institution that holds your account’s investments for safekeeping and sees to it that all IRS and government regulations are adhered to at all times.

Excise Tax: An excise tax is a legislated tax on specific goods or services at purchase such as fuel, tobacco, and alcohol. Excise taxes are intranational taxes imposed within a government infrastructure rather than international taxes imposed across country borders.

IRC: Internal Revenue Code

Qualified Distribution: A tax and penalty-free withdrawal from a Roth IRA

RMD: Required Minimum Distribution – The minimum amount of money you must withdraw from a tax-deferred retirement plan and pay ordinary income taxes on after you reach age 72.

FIRE Away!