What’s the difference between a Traditional IRA and a Roth IRA?

Congress created IRAs through the Employee Retirement Income Security Act of 1974 to incentivize individuals to save for retirement. IRAs were initially limited to workers who did not have pension coverage through their employer. The Economic Recovery Act of 1981 changed that, making all workers and their spouses eligible to open IRAs.

For both traditional and Roth IRAs, funds are typically taxed only once – either before the money is contributed to the account or when it is withdrawn – based on the type of IRA.

A traditional IRA is an individual retirement account that you typically fund with pre-tax dollars, thereby decreasing your taxable income in the year you make a contribution because the contributions may be tax-deductible. However, you may pay tax on the distribution.

Roth IRAs were created through the Taxpayer Relief Act of 1997 to provide an alternative to traditional IRAs. Roth IRAs are named after former U.S. Senator William Roth of Delaware, who sponsored the bill.

With Roth accounts, you won’t receive any tax deductions today but can generally take withdrawals in retirement without paying taxes. You may benefit from a Roth IRA if you’re young, currently in a lower tax bracket or have most of your investments in traditional IRA accounts or retirement plans and are looking to increase tax diversification and flexibility in retirement.

Both traditional IRAs and Roth IRAs have the same annual contribution limit. There is no difference.

If you are eligible, you can contribute up to 100% of your taxable compensation or the contribution limit, whichever is lower. Contribution limits are set every year by the IRS and are tied to cost-of-living adjustments. In 2022, the annual contribution limit is $6,000 if you are age 49 or younger. If you are 50 or older, the IRS allows you to make an additional annual contribution of $1,000 as a catch-up contribution. Keep in mind your total contribution can be no more than $6,000 if you are 49 or younger ($7,000 if you are age 50 or more) for all of your traditional and Roth IRAs combined.

Taxable compensation is generally taxable income that is received from a job or self-employment, and may include:

• Wages
• Salaries
• Tips
• Commissions
• Self-employment income
• Nontaxable combat pay
• Taxable alimony (under divorce agreements entered into prior to 2019)
• Non-tuition fellowship or stipend payments (including payments used in the pursuit of graduate or postdoctoral study)

Sources of income that do not qualify as taxable compensation include:

• Earnings and profits from property (such as rental income), interest or dividends
• Pension or annuity income
• Deferred compensation
• Income from partnerships for which an individual does not provide services that are a material income-producing factor
• Foreign earned income

The eligibility rules for the two types of IRAs are different.

You may contribute to a traditional IRA (up to the maximum IRS annual contribution limit) if you or your spouse (if married) have taxable compensation, regardless of the amount you earn; however, the amount of your contribution that can be deducted from taxes is limited based on the amount you earn and whether you or your spouse participate in an employer-sponsored plan, such as a 401(k) or SIMPLE plan.

You can fully fund a Roth IRA (up to the maximum IRS annual contribution limit) if you have taxable compensation, and your modified adjusted gross income (MAGI) for 2022 is below a specific amount:

• Less than $204,000 if you are married and filing jointly or as a qualifying widow or widower.
• Less than $129,000 if you are filing single, head of household or married filing separately (and you did not live with your spouse at any time during the year).

You can also contribute to a Roth IRA, but at a reduced amount if your MAGI is as follows:

• At least $204,000, but less than $214,000 if you are married filing jointly or as a qualifying widow or widower.
• At least $129,000, but less than $144,000 if you are filing single, head of household or married filing separately (and you did not live with your spouse at any time during the year).
• Less than $10,000 if you are married filing separately (and lived with your spouse at any time during the year).

*If your MAGI falls in one of these given ranges, your tax advisor can help you determine your exact IRA contribution maximum.

You can also fund a traditional or Roth IRA on behalf of your spouse. If he or she earns little to no income, you may be able to contribute up to the maximum IRS annual contribution limit for that account, too, as long as you file a joint tax return.

The most notable difference between a traditional IRA and a Roth IRA is the deductibility of contributions and taxability of withdrawals. If you contribute to a Roth IRA, you will pay taxes on the money before it is deposited into your IRA. However, earnings and withdrawals are generally tax-free. Traditional IRAs are the opposite. Contributions to traditional IRAs are typically tax-deferred, depending on the owner’s income and employer plan participation. However, withdrawals are taxed like income. Thus, if you deduct your contributions, you will later pay taxes on them and any investment earnings at withdrawal.

Roth IRA contributions are not tax deductible. However, your traditional IRA contributions or a portion of them may be deductible, depending on your income and whether you or your spouse participates in an employer retirement plan.

The Saver’s Credit, officially known as the Retirement Savings Contributions Credit, is a nonrefundable tax credit for making contributions to your IRA or employer-sponsored retirement plan. Eligible taxpayers can receive a credit of up to $1,000 if you file an individual tax return or $2,000 if you file a joint tax return, which can help you reduce the amount of tax you owe. The Saver’s Credit can be claimed in addition to the tax deduction for contributions to traditional IRAs or other employer-sponsored retirement plans. Eligible taxpayers who contribute to a Roth IRA may also be able to claim the credit to lower their tax bill.

A required minimum distribution (RMD) generally only applies to traditional IRAs. It is the minimum amount that you must withdraw from your traditional IRA by April 1 of the year after you reach age 72 (for taxpayers reaching 70 ½ after December 31, 2019) and by December 31 of every year thereafter. If you fail to take your RMD by the deadline, you will be subject to a hefty 50 percent excise tax on the amount of the RMD you did not distribute. A major benefit of a Roth IRA is that you generally aren’t required to withdraw a specific amount at or by any certain time.

The term withdrawal is used when you take money out of your IRA. It is sometimes used interchangeably with distribution, which means you receive money from your IRA. Withdrawal/distribution rules differ to some degree for a traditional IRA versus a Roth IRA. However, they are similar in that if you withdraw funds before you are age 59 ½, you may be subject to a 10% early withdrawal penalty, unless you qualify for an exception (set by the IRS -- more on this below).

For traditional IRAs, there are generally three types of withdrawals:

• Early distributions – these withdrawals are made before you turn 59 ½, which exposes you to the 10% penalty if you don't qualify for an exception, as mentioned earlier.
• Regular withdrawals – these are withdrawals made after you reach 59 ½. You will typically pay taxes on this income, based on your income tax bracket.
• Required minimum distributions – these withdrawals are the yearly minimum amount that you must withdraw from your traditional IRA, generally by April 1 of the year after you reach age 72 and by December 31 of every year thereafter. If you fail to take your RMD by the required deadline, you may be subject to a hefty 50% excise tax on the amount of the RMD you did not take.

Roth IRAs generally have four types of withdrawals:

• Withdrawals of regular contributions – these are withdrawals of your original contributions. You are not taxed on such withdrawals, and you are not subject to the 10% penalty.
• Withdrawals of taxable conversions – these are withdrawals of dollars that were originally contributed to a traditional IRA pre-tax and then were subsequently converted to a Roth IRA. You are not taxed on these withdrawals since you paid taxes at the time of conversion, but you may be subject to the 10% penalty if you're not at least 59 ½ and it hasn't been at least 5 years since the conversion (each conversion is subject to its own 5-year holding period).
• Withdrawals of non-taxable conversions – these are withdrawals of dollars that were originally contributed to a traditional IRA after-tax and then were subsequently converted to a Roth IRA. You are not taxed on such withdrawals, and you are not subject to the 10% penalty.
• Withdrawals of earnings – these withdrawals must meet two requirements to be tax-free and penalty-free.
  1. You must make these withdrawals AFTER at least 5 years have passed since first funding a Roth IRA.
  2. AND you must meet one of the following criteria:
     • You are 59 ½ or older at the time of distribution,
     • You become disabled,
     • You use the distribution to build, buy or rebuild a first home (limited to $10,000),
     • Or, you receive the IRA assets due to the death of the original owner.

There are exceptions to the 10% tax penalty that apply to both early distributions from traditional IRAs and Roth IRAs. Per the IRS, for the 10% penalty to be waived, the distributions must meet one or more of the following criteria:

• Occur as a result of the individual being a beneficiary of a deceased IRA owner
• Occur because the individual is disabled
• Are in substantially equal payments over the current owner’s life expectancy
• Are for unreimbursed medical expenses that are more than 7.5% of the owner’s adjusted gross income
• Are for medical insurance premiums because of unemployment
• Are used for qualified higher-education expenses
• Are used to build, buy or rebuild a first home (up to $10,000)
• Are used for expenses related to the birth or adoption of a child (up to $5,000 taken within one year following the event)
• Occur if the individual is a reservist called to active duty after September 11, 2001
• Are used to satisfy an IRS levy
• Occur as a result of certain federally declared disasters for which Congress authorized specific provisions (including hurricanes, severe storms, tornados, flooding, wildfires, Coronavirus, etc.)

You generally must meet two criteria to be able to roll over your employer retirement plan to an IRA:

• Your plan must allow you to take a distribution.
• The distribution must be eligible to be rolled over. Certain distributions, such as RMDs and hardship distributions, are generally not eligible.

Additionally, Roth 401(k) assets may only be rolled over to a Roth IRA. Pre-tax 401(k) assets can be rolled over to a traditional or a Roth IRA. But, if you roll over pre-tax 401(k) assets to a Roth IRA, it's considered a Roth conversion, and the amount that's rolled over will be taxed.

It's also important to know that there are differences between employer plans and IRAs. Make sure you understand your options before rolling over. A financial advisor can also help you determine whether rolling over makes sense for you.

Yes, you can transfer your IRA to another provider at any time without tax consequences or tax reporting as long as the assets move directly from your current IRA provider to your new IRA provider.

A rollover may also be an option. A rollover must be deposited into the same IRA or another eligible IRA by the 60th calendar day (not business days) from the day following receipt of the cash or assets. If the 60th calendar day falls on a Saturday, Sunday or holiday, the rollover must be deposited on the last business day before the

Both traditional and Roth IRAs can be inherited. When someone inherits an IRA, they will have to take distributions from the inherited IRA by a certain deadline, regardless of whether it's a traditional or Roth IRA. The amount they must take from the inherited IRA and the deadline to take it vary depending on the beneficiary.

The main difference between traditional and Roth IRAs from an inheritance perspective is who pays the taxes. With a traditional IRA, the heir pays taxes on the distributions at their income tax rate. With a Roth IRA, the original owner paid taxes on the contributions, so the heir can generally take tax-free distributions.

If you have questions about inheriting an IRA or leaving one to a loved one, consider discussing this with a financial advisor.

Investing in accounts with different tax treatments can provide you flexibility (and potentially higher after-tax income) in retirement. As a result, you should consider contributing to both traditional and Roth IRAs. However, the focus of your contributions may change depending on your life stage and tax situation. For example:

A traditional IRA tends to be more beneficial when:

• You expect your tax rate in retirement to be lower than your current tax rate.
• You are in a high bracket today and would prefer the immediate tax savings of a deduction (if eligible).

A Roth IRA tends to be more beneficial when:

• You are young, in a low tax bracket, or expect your tax rate in retirement to be higher than your current tax rate.
• You can forgo the deduction today for the prospect of tax-free retirement income.
• You plan to pass these assets to your heirs instead of spending them in retirement.
• You expect higher income from taxable sources in retirement and would benefit from a Roth's tax-free income to help manage your taxes and Medicare premiums in retirement.
• You have most of your retirement assets in traditional IRAs or 401(k) accounts.

Get started on navigating IRAs by finding an Edward Jones financial advisor today. Our financial advisors can help you understand what questions to ask as you decide which IRA might be right for you. They'll work with you to build a solid long-term strategy as you plan for and enjoy your retirement.