Traditional IRA v. Roth IRA – Compare & Contrast

What’s the difference between the two types of IRAs?  And what is similar?

Photo credit: jb

You probably know a little bit about this subject – like one IRA is deductible on your income taxes, and the other one has some kind of tax benefit… but the differences are hard to understand, and can be even harder to explain!  Below are the major differences between the two, followed by the similarities.  This discussion is liable to be useful as you consider which kind of IRA is best for you (and both could be best for you, at different times in your life).

Differences Between Traditional IRA and Roth IRA

Deductibility is a feature of the Traditional IRA (Trad) that is not available in the Roth IRA (Roth).  What this means is that, subject to the limits we discussed here, you may be able to deduct the amount of your contribution to your Trad from your Gross Income in the year of the contribution.  When the Traditional IRA was originally introduced in 1974, the deductibility feature was not included.  This was added in 1986, and is one of the primary reasons that Trads have remained as popular as they are to this day.  At the time of the introduction of the deductibility feature, very few companies offered 401(k) plans so the Trad offered one of the only tax shelters available to nearly every taxpayer.

Tax treament is another major difference between the two kinds of IRA.  The Trad’s distributions are always taxable (if not rollover distributions) as ordinary income, while the Roth’s distributions are always tax-free (as long as they meet the requirements, such as after age 59½).  What is also very different about the two is that your contributions to a Roth are always available for withdrawal at any time for any reason – tax free.  The growth in the Roth (interest, dividends, capital gains) would be taxed and subject to penalty if withdrawn for an ineligible reason, though.  The Trad does not have such a provision.

Required distributions are the final major difference covered here.  The Trad has Required Minimum Distributions (RMDs) that must begin at the owner’s age 72, while the Roth has no requirement for distribution.  In other words, the Roth IRA never needs to be distributed during the IRA owner’s life, while the Traditional IRA must be distributed beginning at the owner’s age 72.

Similarities Between Traditional IRA and Roth IRA

Income requirement. A component of the requirements of both the Trad and the Roth is that the holder (or the holder’s spouse) must have earned income in the year of the contributions.  The income must be at least equal to the total of all IRA contributions for the year.  This includes two additional types of contributions: spousal contributions and non-deductible contributions.

Spousal contributions are allowed for both the Trad and the Roth, and they essentially allow a spouse with income to contribute to the IRA (either variety) of the spouse who either does not have income, or whose income is below the maximum available contribution for the tax year.  The contributions are limited, however, to the total of both spouses’ earned income for the tax year.

Earned income, for the purposes of IRA contributions, includes wages, salaries, tips, commissions, self-employment income, or alimony (or separate maintenance payments).  Not included as earned income are earnings and profits from property (rental or royalty), interest income, dividends, pensions, annuities, deferred compensation (such as 401(k) distributions), certain non-participatory partnership income, and capital gains.

Non-deductible contributions to a Traditional IRA are allowable when your MAGI is above the limits (described here).  In essence, if your income is too high to make either a Roth contribution or a deductible Trad contribution, you are allowed to make a non-deductible contribution of up to the maximum amount allowable for the year into your Trad IRA.  These contributions are after tax, and so when distributed there will be tax only on the growth that has occurred on that contribution.  Non-deductible contributions are a way to defer tax on the growth of funds in an account, and are also available as a spousal contribution.

Tax Year Specification. Trad and Roth contributions must be made for a specific tax year.  That is, since there are strict limits on the amounts that can be contributed, you must specify the tax year of the contribution to your IRA.  You are generally allowed to contribute for a tax year beginning on January 1 and ending on the tax due date for the year (generally April 15 of the following year).  In other words, you may make your 2019 contribution to your IRA at any time between January 1, 2019 and April 15, 2020.

The same deadline applies to establishing the account as well.  You can even file your tax return early, indicating a contribution to your Trad IRA (and deducting it from your gross income) before you make the contribution!  Just make sure that you do go ahead and make the contribution… the IRS has very little sense of humor about things like that!

Penalty for withdrawal applies to ineligible distributions from either type of account.  A 10% penalty will be applied to any distribution from an IRA of either variety that is not specifically allowed under §72(t), above and beyond the ordinary tax that would be applied to the distribution.