Self-directed investors have a wide range of retirement account options, but by far most prevalent are Traditional IRAs or Roth IRAs. Both feature the same annual contribution limit (as of 2019) and both allow alternative IRA investments like real estate and precious metals, so what’s the difference?
Traditional and Roth IRAs both have considerable tax advantages, yet they are different. In a nutshell, Traditional IRAs offer a tax break in the near term and the opportunity for lower taxes down the road. Roth IRAs save their tax benefits exclusively for later in the account holder’s life.
|Traditional IRA||Roth IRA|
|Taxes Paid NOW |
|None - Deduct Traditional IRA deposits from your taxable income||All - Include Roth IRA contributions with your taxable income|
|Taxes Paid LATER |
|Less - Pay taxes on distributions, hopefully at a lower rate||None - Qualified Roth distributions are 100% tax-free|
Let’s highlight these differences with examples:
Joe has a Traditional IRA and earns $50,000 per year, putting him at an income tax rate of 22%. He elects to make a $5,000 Traditional IRA contribution, which he may deduct from his income for tax purposes. As such, Joe will only pay taxes on $45,000 instead of his full income of $50,000.
By enjoying a tax deduction on his contribution, Joe will eventually have to pay income taxes on his Traditional IRA distributions. However, to garner the full benefits of a Traditional IRA, Joe waits until he’s only earning $35,000 per year and has thus entered a lower income tax bracket (12%).
The Bottom Line – Joe saved $1,100 in taxes ($5,000 x 22%) in his contribution year, and then saved an additional 10 cents on every distributed dollar once he reached a lower tax rate. In the meantime, his annual Traditional IRA earnings were tax-deferred in the same manner as Joe’s contribution.
Sally also earns $50,000 per year and decides to open a Roth IRA. She makes the same $5,000 contribution, but she can’t deduct it from her income the way Joe can. Why would Sally contribute to a Roth IRA if she can’t enjoy an immediate tax benefit? It’s because she may not have to pay any taxes on her distributions.
Qualified Roth IRA distributions can be 100% tax-free if the account holder is at least 59 ½ years of age and waits at least five years after his or her initial contribution. So, Sally may contribute $5,000 and have to pay income taxes, but if that $5,000 grows to $25,000 five years later and she reaches age 59 ½ during that time, she could distribute the full $25,000 without paying another penny to the IRS.
The Bottom Line – Sally had to pay taxes on her contributions, but she paid $0 in taxes upon qualified withdrawal of her Roth IRA earnings. As in Joe’s example, Sally’s account was able to grow tax-deferred over the course of her investing career.
As you can see, Traditional and Roth IRAs offer a suite of tax benefits with near- and long-term implications. If you’re deciding between these two accounts, New Direction Trust Company encourages you to weigh your current situation, consider your future situation, and consult with your CPA or tax professional as needed. For more information about self-directed investing or to open an IRA, please don’t hesitate to give us a call at 877-742-1270 or send us an e-mail at email@example.com.