Roth vs. Traditional IRA: What You Need to Know

By Markets Fool.com

IRAs (Individual Retirement Accounts) are a critical retirement savings tool for countless Americans. There are two types of IRAs, the traditional and the Roth, and it's important to understand the benefits of each as well as their differences. The chart below will help you compare the advantages of a regular or traditional IRA versus a Roth to see which is a better solution for your retirement needs.

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Similarities between traditional and Roth IRAs

Both traditional and Roth IRAs are designed to serve as a means of saving for retirement. Though there are other uses for both types of account, as we'll discuss below, the primary purpose behind each is to allow workers to put aside money for retirement. Unlike a 401(k) plan, which is run through an employer, IRAs are opened at the individual level, typically through a bank or brokerage house.

When you put money into an IRA, your goal should be to invest that money so that it grows over time. However, there's a limit as to how much you can contribute each year to an IRA, and it's the same for both types. For 2016, the annual limit is $5,500 if you're under 50. Those who are 50 or older are allowed a catch-up contribution of $1,000 for a total of $6,500.

Traditional IRAs

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One major benefit of traditional IRAs is that the money you contribute goes in on a pre-tax basis. In other words, you'll get an up-front tax break by putting money into your account today, and whatever earnings your contributions generate won't be taxed until the time comes to take withdrawals. Once you reach retirement, however, your distributions will be taxed as ordinary income.

If you withdraw money from a traditional IRA before you reach the age of 59 1/2, you'll be hit with a 10% penalty and taxed on your distributions. There are a few exceptions though. You can withdraw up to $10,000 from a traditional IRA without incurring a penalty if you're using the money to buy a first-time home. You can also take an early withdrawal and avoid a penalty if you use the money to pay for college for yourself, a spouse, or a child. Furthermore, with a traditional IRA, you can't just let that money sit in an account forever; you're required to start taking distributions once you reach age 70 1/2.

Roth IRAs

Whereas traditional IRA contributions are made with pre-tax dollars, if you put money into a Roth IRA, you won't get a tax break immediately. However, when the time comes to take distributions in retirement, your withdrawals will be completely tax-free.

If you withdraw your principal contributions from your Roth IRA (meaning, the exact amounts you put in, not your investment gains) before you reach 59 1/2, you can avoid the penalty you'd get by taking an early withdrawal from a traditional IRA. However, if you withdraw your profits, you may be assessed a penalty. Now there's an exception for first-time homebuyers, who can withdraw $10,000 in profits without penalty provided the money has sat in a Roth for at least five years. You can also take an early withdrawal to pay for college for yourself, a spouse, or a child without incurring a penalty. And unlike traditional IRAs, Roth IRAs don't impose required minimum distributions. This means that if you don't need the money by the time you turn 70 1/2, you can let it sit in your account and continue to grow.

Keep in mind, however, that not everyone can contribute to a Roth IRA. There are annual income limits that come into play to determine eligibility, and if you make too much money, you'll be limited to a traditional IRA alone.

The following chart summarizes the key differences between traditional and Roth IRAs:

Traditional IRA

Roth IRA

Annual contribution limit

$5,500 if you're under 50; $6,500 if you're 50 or older

$5,500 if you're under 50; $6,500 if you're 50 or older

Earliest withdrawal age to avoid penalties

59 1/2 for contributions and earnings (exceptions apply)

59 1/2 for earnings (exceptions apply); contributions can be withdrawn at any time

Required minimum distributions

Starting at 70 1/2

No required minimum distributions

Taxes on contributions

Contributions are made with pre-tax dollars

Contributions are made with after-tax dollars

Taxes on withdrawals

Withdrawals are taxed as ordinary income

Withdrawals are tax-free

Income limits

No income limits

Current income limits are $132,000 for single filers and $194,000 for joint filers

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Though traditional and Roth IRAs allow you to achieve the same goal of funding your retirement, each has its own set of rules and complexities. No matter which type of IRA you decide to open, the key is to do so as early in your career as possible. The more time you give your money to grow, the greater your chances of amassing a sizable nest egg by the time retirement rolls around.

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