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Traditional IRA vs. Roth IRA: Which is better for taxes?

April 30, 2014

| MoneyRates.com Senior Financial Analyst, CFA

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 that 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. You can only deduct contributions up to $5,500 per year (or $6,500 if you are age 50 or older) and there is a 10 percent penalty if you take money out of a traditional IRA before you are age 59 1/2.

Also, the amount you can deduct may be even more limited if you are a high earner or if you are covered by a retirement plan at work. 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.

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.

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.

Your responses to ‘Traditional IRA vs. Roth IRA: Which is better for taxes?’

Showing 5 comments | Add your comment
Richard Barrington

16 May 2014 at 5:22 am

Brian, I’m not sure I am understanding your question correctly, so please correct me if I’m wrong, but if your thought is that traditional IRAs have an advantage because the initial tax deduction will allow you to make (and invest) a larger contribution, here’s the thing: while that might make a traditional IRA look larger than a Roth IRA while both are up and running, you still face that tax liability on the back end with a traditional IRA, but not with a Roth IRA. Unless there has been a change in tax rates, this will neutralize the initial advantage of a traditional IRA.

Richard Barrington

16 May 2014 at 5:21 am

jsf12, what you are pointing to, the benefit of compounding tax-free, is a benefit that both traditional and Roth IRAs provide. Since this article was about differences between the two, it focused on points of differentiation rather than reiterating common attributes. Sorry if the language was not clear on this.

jsf12

6 May 2014 at 7:32 am

How does someone with a title of "Senior Financial Analyst" manage to miss the point so completely. I understand you need to dumb it down a little for a financially illiterate audience, but that should not eliminate the key concepts. The key to either kind of IRA is that the compounding of earnings occurs without continuous taxation. By paying either the tax on the smaller amount up front or the tax on larger amount withdrawn, you end up with more total after tax than if you had paid taxes on the earnings each year as they occur. The effective differences between Roth and Traditional are even harder to explain to a mathematically illiterate audience, but that is no excuse for the fundamentally wrong explanation in this article.

Bobert

6 May 2014 at 5:15 am

I really do think the Roth is the way to go if you qualify for it. Tax rates are on their way up with the government taking over health care, and I would much rather pay today than pay in 30 years when the government really has run out of money and is taxing us into oblivion. I hope it doesn't come to this, but better to be prepared. As for saving to the Roth, actually most financial experts recommend this. Watch Suzey Orman or Dave Ramsey sometime and see how much they talk about it. They also recommend switching a whole life insurance for term life insurance policy which you can get for about $25 bucks a month from LifeAnt, and save the difference. I used to pay $340 for mine, and now I pay $32. I save the difference in my Roth like a good boy (well most of it anyway) and hopefully the market doesn't crash too far in the next correction which is sure to come soon. I think the article really missed pointing out that a 401k is the #1 place to save for retirement first IF your company has a match. Thats free money that can not be passed up. Small changes really can add up to big savings. It is about being smarter, not complete sacrifice, at least in my situation.

Brian

5 May 2014 at 4:54 pm

I never hear anyone talk about what the advantage is when using the Traditional and reinvesting the tax savings! Thoughts?

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