US Pensions Explained: The Traditional IRA and Roth IRA compared

This article will outline some of the major differences between ad Roth and Traditional IRA. For expert tax and accounting support for US pensions contact us.

What is an IRA

An Individual Retirement Account (IRA) is a monetary investment account that is optimised against-tax to support individuals saving towards retirement. The IRS also uses the acronym “IRA” in placement for “Individual Retirement Arrangements”. Individual Retirement Arrangements broadly refer to individual retirement accounts, retirement annuities and other trusts or custodial accounts that act as personal saving plans with tax advantages for saving money towards retirement.

Traditional and Roth IRA

Traditional and Roth IRS’s are two retirement saving arrangements that the IRS offers to tax payers. Below we will be explaining how the two IRA’s work and offering a comparison to help individuals decide which is the best type of IRA for them.

Click the button below to see our Roth IRA vs Traditional IRA calculator to get a more accurate idea of the return on investment off each of the IRA’s

How Traditional IRAs Work

A Traditional IRA allows individuals to save pre-tax income and use it for investments that can grow tax-deferred. Under this savings account the IRS does not assess capital gains or dividend income tax until withdrawals are made. This means that tax will not be paid on savings until the point of money is taken out of the account.

Investments for the traditional IRA for a given tax year must be made before the US tax filing deadline (typically April 15th ).

Maximum contributions - 100% of earned compensations

Taxpayers can contribute 100% of any earned compensation up to a specific maximum dollar amount. This amount changes yearly- see out Traditional IRA Threshold chart to identify how much can be contributed for a specific year.

Contributions may be tax-deductible depending on IRA holders income, tax-filing status and other factors.

If an individual has both a Traditional IRA and an employer-sponsored retirement plan, the IRS may limit the amount of contributions that can be deducted from taxes.

For example:

• In 2021, if a taxpayer has a 401k or pension program the individual would only be able to take full deductions if their MAGI was $66,000 or less for singles and $105,000 or less if married couple file jointly.

• With MAGIs of $76,000 for singles and £125,000 for married couples to IRS allows no deductions.

Age of distribution: 59 ½

Account holders can begin taking money out of the account at the of age 59 ½. Once the account holder turns 72 years minimum distributions (RMDs) must be taken each year. The minimum and maximum distributions allowed at different account holder ages is listed in the Traditional IRA Age Distributions chart.

Funds removed before full retirement eligibility incur 10% penalty on the amount withdrawn and taxes at standard rates. There are some exceptions for penalties:

• Money is use for purchase or rebuilding of first home (limited to $10,000)

• You become disable before distributions

• Your beneficiary receives the asset after your death 

• You use the assets for reimbursed medical expenses

• Used for medical insurance cost after losing job

• Your distribution is part of the SEPP

• Asset is used for higher-education expenses 

• Expenses incurred from adoption of a child

• The asset is distributed as a result of IRS levy

• The amount is a return on non-deductible contributions

• You are in the military and called to active duty for more than 179 days

How Roth IRAs work

A Roth IRA is a retirement arrangement that allows money to be invested after the point of tax. However, unlike with a traditional IRA, account holders do not have to pay tax on their investments at the point of withdrawal.

Roth IRAs only allow the holder the contribute earned income, ineligible funds which include:

• Rental income

• Interest income

• Pension or annuity income

• Stock dividends and capital gains

Regular contributions must be made in cash, i.e., they cannot be securities or assets.

Not everyone can have a Roth IRA

Roth IRAs are limited by your income; you cannot contribute to a Roth IRA if your income is too high. To find out who can have a Roth IRA in a given tax year based on income see this chart.

Maximum contribution limit changes yearly

The contribution limit changes yearly, for example, in 2021 the limit is $6,000 a year unless you’re 50 or over, then the limit is $7,000. To find out the contribution limits on Roth IRA’s and deduction limits for Traditional IRAs for a given tax year visit our page on the topic: Roth IRA and Traditional IRA Thresholds.

No requirement to withdraw

The IRA can be maintained indefinitely, there is no requirement to withdraw as there is with a 401k and Traditional IRA.

Roth IRA or Traditional IRA?

Which IRA suits you is entirely dependant on your individual situation, and a judgement call on what you feel your tax situation come retirement age.

For those who feel their marginal tax rate will be higher during their retirement age a Traditional IRA would be a better option. This is because of the tax-deferred nature of a Traditional IRA, allowing any investments to be taxed at a lower rate than if they were to be taxed in a traditional savings account or alternatively a Roth IRA .

A Roth IRA suits those who feel their tax rate will be higher in retirement. The Roth IRA allows individuals to pay tax on their contributions now which means upon distribution they receive the payments tax free. In contrast to the Traditional IRA, any growth from investments are allowed to grow tax-free.

Either IRA is a sound investment for your future, for any help regarding your Roth IRA or traditional IRA do not hesitate to contact us