When it comes to retirement planning, some key knowledge you need to know is the differences between a Roth IRA vs Traditional IRA.

I don't know about you, but when I first started learning more about retirement planning and investing I was confused with all the jargon.

However, it is VITAL that you understand your options for saving for retirement. Unfortunately, most Americans aren't saving enough to keep the same lifestyle they have now in retirement.

In fact, research shows that just 16% of Americans are saving over 15% of their income for retirement.

From what I've heard from others, one of the reasons they aren't actively investing is because they don't understand it.

Because of this, they avoid it all together and figure they'll deal with it later. This is a huge mistake!

Millionaires are made by patiently investing over a long period of time. If you start investing early, you are WAY more likely to build wealth and be secure in retirement.

That being said, let me lay out the differences between a Roth IRA vs a Traditional IRA for you! This way, you'll be equipped to take a step forward with confidence and start investing :)

Related:

The main difference between a Traditional IRA and a Roth IRA relates to when and how the money that you put into the IRA is taxed. 

When contributing to a Roth IRA, you use after-tax dollars. However, the money you take out in retirement is tax-free. Additionally, the money you earn on your investment grows tax-free.

🔑Key point: When you withdraw money from your Roth IRA, you will not owe any taxes, because you already paid taxes on your contributions. 

On the other hand, you contribute to a Traditional IRA pre-tax. The downside is when you pull the money out there will be a taxable transaction. Both the money you contributed AND the earnings will be taxed at the time of withdrawal. Essentially, you are deferring the tax you’ll have to pay to a later date.

🔑Key point: When you withdraw money from your Traditional IRA, you will owe taxes, because your contributions were made pre-tax. 

When only considering the tax ramifications of each type of account, it comes down to what you expect your income to do.

If you expect to be in a higher income tax bracket in retirement than you are in now, a Roth IRA may be the best option.

On the other hand, if you expect your income to decrease over time, then the Traditional IRA might make more sense.

Many people tend to think that their income in retirement will be lower than it is today.

However, what many people fail to realize that although you likely won’t have your traditional wage income or business income, you could potentially have less tax deductions and credits due to being empty nesters.

With no dependents in retirement, you won’t be eligible for the child tax credit ($2k per child), childcare credit (for working families), or any of the education credits for kids in college. 

As a result, your taxable income might actually be higher in retirement even though you aren’t earning a wage anymore! 

I recommend consulting with your tax advisor and financial advisor and discussing retirement planning.

There are no age limits on contributions to either a Traditional or Roth IRA. However, there are income limits for contributions to a Roth IRA (there is a work-around this limit discussed later). 

While anyone can contribute to a Traditional IRA, only those with earned income below a certain level can contribute to a Roth IRA. 

For single tax filers, your Modified Adjusted Gross Income (MAGI) must be under $139,000 for the tax year 2020 to contribute to a Roth IRA. If married and filing jointly, your MAGI must be under 206,000 for the tax year 2020.

As mentioned previously, there is a work-around this rule, discussed later.

Many times with retirement income, there is something called a required minimum distribution (RMD for short).  This is an amounts the IRS requires one to withdraw annually. The purpose is to spread out distributions from one's retirement account over their life expectancy.

In other words, the IRS doesn't want you to defer taxes, so they require you to make distributions that are taxable.

A Traditional IRA is subject to RMD’s, beginning at age 70 ½. 

On the other hand, there is no RMD requirement for a Roth IRA if you are the original owner.

This makes it beneficial to have a Roth IRA because if you don’t need the money, you don’t have to take withdrawals from the account.

Furthermore, if you don’t touch the account, when you pass away, the beneficiary of your account can enjoy tax-free distributions. 

The maximum amount you can contribute to either a Roth or Traditional IRA is $6,000 per person per year , or 100% of earned income, whichever is less. 

You can make a “catch up” contribution of $1,000 (for a total contribution of $7,000) if you are 50 or older without any penalties. 

For both a Roth and Traditional IRA, you can open an account for a minor child. In this case, a parent will be the custodian on the account.

However, keep in mind the contribution rules! The maximum amount you can contribute is the LESSER of $6k (for 2020) or 100% of earned income.

For example, let's say your 12-year-old child makes $3,000 mowing lawns during the summer. If they have no other income during the year, the maximum amount you can contribute to their IRA is $3,000.

The reason you can only contribute $3,000 is because in this case their earned income is less than the $6k contribution limit.

For those who are over the income limitations for contributing to a Roth IRA, you can still take advantage of the tax benefit of the Roth IRA by doing a Roth IRA conversion. 

When you convert the Traditional IRA to a Roth, you will pay tax on the amount you convert. 

However, the good news is, you can enjoy the tax-free distribution on the contributions and earnings upon withdrawal later! 

If you are in this situation, it means that you have been phased out of making a Roth IRA contribution because of the income limits. As a result, it might be smart for you to make the conversion from a Traditional IRA to Roth IRA if you expect your income to continue to increase.

Let’s look at an example, because it might be best explained that way. 

Say you have $6,000 in a Traditional IRA. If you leave that money for 30 years and it earns 10% average over those 30 years, it will grow to about $105k. 

If you keep the money in the Traditional IRA, you will pay taxes on the entire $105k (contributions AND earnings) every time you make a withdrawal. 

However, if you convert the $6,000 from a Traditional IRA to a Roth IRA in the year you make  the contribution, you will only pay taxes on the $6,000. Then, you can enjoy tax-free distributions on the $105k in retirement! 

It makes a big difference, $99k (105,000 - 6,000) of taxable income, to be exact. 

A word of caution when doing this- it only makes sense to make the conversion if you have the cash to pay the tax bill! Otherwise, you'll pay a penalty for withdrawing from your retirement account early. This cancels out the benefit of the conversion.

Ultimately, when it comes to deciding between a Roth IRA or a Traditional IRA, it depends on what you expect your income to do in the future. This is, in my opinion, the most important consideration.  

You can either enjoy the tax-free benefit today , or enjoy tax-free distributions in the future. 

That’s A LOT of information to chew on- if you’re unsure of what you should do in your particular situation, I highly recommend finding an investment professional. 

We went to Dave Ramsey’s website and found an investment professional there, and if you follow his plan, I’d highly recommend you do so as well!