Roth IRA vs. Traditional IRA

What Is an Individual Retirement Account (IRA)?

An individual retirement account (IRA) is one of several tax-advantaged retirement savings accounts available in the market today. IRAs are funded exclusively by the account holder, or in some cases by close relatives. IRAs can be managed by a custodial service or privately owned and managed.

The two most commonly utilized IRA structures are Traditional IRAs and Roth IRAs, which provide distinct tax incentives for retirement savings. The key factor to consider when choosing between a Roth IRA and a Traditional IRA is whether your current income tax rate is higher or lower than your expected future income tax rate.

The IRS levies a penalty for premature withdrawals or distributions from an IRA if the account holder attempts to make a withdrawal or take a distribution before turning 59.5 years old. That early distribution and withdrawal penalty is typically 10% of the distribution total, in addition to any capital gains taxes due on investment earnings.

Withdrawals may be taken without penalty when the IRA has been open for 5 or more years, and the 401(k) investor has reached the age of 59.5. However, other tax implications may apply even when the early distribution penalty does not.

➤ Learn more about investing Bitcoin in a retirement account.

What Is Time Preference?

Choosing an IRA structure requires thoughtful analysis on whether it is preferable to pay income tax on IRA contributions now, or pay income tax on IRA distributions in the future. Sometimes, an individual would prefer to pay taxes at an earlier date and avoid greater taxes in the future, or vice versa. When an investor expects their income to increase over time, the taxpayer may prefer to pay income taxes now and avoid paying a higher income tax rate in the future. Alternatively, investors at their peak income level may wish to pay taxes at a later date when they fall to a lower tax bracket.

Selecting the appropriate type of IRA is a strategic decision based on time preference, the marginal tax rate, and prospective income.

Marginal Tax Rate

One way to conceptualize time preference is to analyze the marginal tax rate, which represents the percent tax increase for each additional dollar of income. The U.S. tax model is progressive, meaning that individuals are taxed at a higher rate as their income increases. The lowest tax bracket owes 0% and the highest bracket owes nearly 40% on each additional dollar of income. If an individual believes their income will increase in the future, they have a higher time preference for paying taxes than an individual who believes their income will decrease in the future.

Prospective Income

Prospective income is an individual’s anticipated future income at a specified point in time. Prospective income is estimated based on the trajectory of an individual’s career and plans for future income. If an individual expects increased prospective income, a Roth IRA may be favorable. Alternatively, a reduction in future income would render a Traditional IRA more favorable.

Roth IRA

The distinguishing feature of a Roth IRA is that the retirement account is funded with post-tax income, which means that neither the principal investment nor capital gains are taxable once the IRA matures. Moreover, Roth IRAs have no required minimum distribution (RMD) schedule, which means the owner has the option to name a beneficiary to inherit the IRA in full. The Roth IRA’s most notable limitation is the $6,000 cap on annual contributions for individuals under the age of 50, and $7,000 cap for individuals over the age of 50.

Traditional IRA

Traditional IRAs differ from Roth IRAs because they are funded by pre-tax investments. Thus contributions are deductible in the present year. However, that also means taxes are paid upon distribution at the individual’s income tax rate, which may be higher depending on when the IRA was created. If an individual anticipates a lower future income, and thus a lower future tax bracket, then a Traditional IRA may be more favorable.

Like a Roth IRA, a Traditional IRA also has a maximum yearly contribution of $6,000 for individuals under the age of 50, and $7,000 for individuals over the age of 50. The owner of a Traditional IRA is subject to required minimum distributions (RMDs) when that individual reaches 72 years of age.

What Assets Can Be Invested in an IRA?

The vast majority of asset classes may be invested within an IRA, but there are several distinct categories which are not permitted.

Prohibited Asset Classes

Antiques and collectibles, life insurance products, and personal real estate may not be contributed to an IRA. Funding a prohibited investment will result in penalties, additional taxes, or other punitive measures taken by the IRS.

Prohibited Transactions

There are limitations on the types of transactions that are permitted with an IRA. For example, an individual may not lend themselves money from the IRA, use IRA funds to purchase property, or sell property to the IRA.

If a restricted asset class is invested in an IRA, or a prohibited transaction occurs, the IRA may be disbanded and its owner may be penalized.

How Are IRA Capital Gains Taxed?

Capital gains accumulated from a Roth IRA investment are tax-free, so long as the account has been open for at least five years and the IRA’s owner is at least 59.5 years of age. Alternatively, in a Traditional IRA, capital gains are taxed at the investor’s income tax rate at the time of distribution.