Traditional and Roth IRA: advantages and disadvantages

Traditional and Roth IRA: Overview

Two popular personal retirement accounts (IRAs) are the traditional IRA and the Roth IRA. They have many advantages and some disadvantages for retirement savers.

The IRA was created decades ago, when fixed-income pension plans were declining. As workers begin to control their retirement savings, IRA has become more and more popular, and it provides individuals with the opportunity to save for retirement in tax-friendly accounts.

In a traditional or Roth IRA account, you can invest in various traditional financial assets such as stocks, bonds, exchange-traded funds (ETF) and mutual funds. You can use a self-directed IRA (you, the investor, not the custodian, makes all investment decisions) for a wider range of investments-commodities, certain precious metals, real estate, and even P2-interbank loans. However, no matter what type of IRA, you are not allowed to invest in life insurance or collectibles, such as art, carpets, antiques, gems, and stamps.

IRA accounts are relatively easy to set up, but the rules for managing these accounts vary. Although they provide tax benefits, the amount you can contribute is limited.

Key points

  • Traditional and Roth IRAs are popular retirement accounts and are easy to set up.
  • Both provide a tax-friendly way to save and invest for retirement.
  • However, there are limits on the amount you can contribute and the penalties for early withdrawal.

Benefits of traditional and Roth IRA

IRA provides several obvious advantages, including the following.

Tax-free growth

Both Roth and traditional IRA provide tax-free asset growth. This means that once the funds are deposited in the account, there is no tax on the dividends or capital gains received before the investment is distributed.

tax deduction

Roth IRA contributions are made in U.S. dollars after tax, while traditional IRA contributions are made in U.S. dollars before tax. This means they can be deducted from your income-in most cases-despite certain restrictions.

The deduction depends on your income level and whether you are in a workplace retirement account, such as a 401(k). The IRS explains the traditional IRA deduction rules for 2021 and 2022 as follows, which apply to workers covered by workplace retirement accounts. The limit is determined based on income and individual tax declaration status. As personal income increases, the amount of tax relief can be partially or completely reduced.

Traditional IRA deduction limits for 2021 and 2022
application status Revised AGI in 2021 2022 modified AGI deduct
Single or head of household USD 66,000 or less USD 68,000 or less Maximum contribution limit deducted in full
More than US$66,000 but less than US$76,000 More than US$68,000 but less than US$78,000 Partial deduction
USD 76,000 or more USD 78,000 or more No deduction
Married joint application or eligible widow (er) 105,000 USD or less 109,000 USD or less Maximum contribution limit deducted in full
More than US$105,000 but less than US$125,000 More than US$109,000 but less than US$129,000 Partial deduction
USD 125,000 or more USD 129,000 or more No deduction
Married separate declaration Less than 10,000 USD Less than 10,000 USD Partial deduction
10,000 USD or more 10,000 USD or more No deduction

If you declare separately and do not live with your spouse at any time of the year, your IRA deduction will be determined under the “single” declaration status.

Both traditional IRA and Roth IRA have the same contribution period. You can contribute to your IRA for the entire calendar year and before April 15th of the following year.

Disadvantages of traditional and Roth IRA

Although the advantages of IRA usually outweigh the disadvantages, there are still some disadvantages to be aware of.

Contribution limit

The IRA has strict contribution limits. To contribute to the IRA, you or your spouse need to earn income. In 2021 and 2022, the maximum contribution per person is US$6,000, and those 50 years of age and above can make a supplement of US$1,000 in 2021 and 2022. However, if your revised adjusted gross income (MAGI) exceeds a certain level, you may not be able to contribute to the Roth IRA.

Roth IRA income limits for 2021 and 2022
application status Revised AGI in 2021 2022 modified AGI Contribution limit
Married joint application or eligible widow (er) Less than 198,000 USD Less than 204,000 USD 6,000 USD (if you are 50 years of age or older, 7,000 USD)
US$198,000 to US$207,999 US$204,000 to US$214,000 reduce
208,000 USD or more 214,000 USD or more Can not be ignored
Single, head of household, or married declaration separately (and you did not live with your spouse at any time of the year) Less than USD 125,000 Less than $129,000 6,000 USD (if you are 50 years of age or older, 7,000 USD)
US$125,000 to US$139,999 US$129,000 to US$144,000 reduce
USD 140,000 or more 144,000 USD or more Can not be ignored
Married separate declaration (if you live with your spouse at any time of the year) Less than 10,000 USD Less than 10,000 USD reduce
10,000 USD or more 10,000 USD or more Can not be ignored

If you are married and file your taxes separately and you do not live with your spouse at any time of the year, your tax status is single.

Punishment

Since IRA is used for retirement, if you withdraw money before retirement age, you will usually be subject to certain penalties.

With a traditional IRA, you will face a 10% fine of the tax owed on any withdrawal before the age of 59½.With Roth IRA, you can withdraw an amount equal to your contribution penalty, and Tax-free at any time.

However, if you hold the account for five years and are 59½ years old, you can only withdraw your income without a 10% fine.

There are some exceptions to these early exit rules. Early distribution of income for these reasons is considered an exception: it is taxed as income but not subject to a 10% penalty. The most popular ones include:

  • Withdraw up to $10,000 to help pay for your first home, your spouse, children or grandchildren
  • Withdraw funds to pay for college expenses
  • Withdraw up to $5,000 within one year after your child’s birth or adoption
  • Distribution of unreimbursed medical expenses or health insurance premiums when unemployed in excess of 7.5% of the adjusted total income for the year

Need to withdraw

From the time you turn 72, your traditional IRA has mandatory withdrawals, called the minimum required distribution (RMD). The withdrawal amount is calculated based on your life expectancy and will be added to the taxable income for the current year. If you do not participate in RMD, you will be fined 50% and owed taxes.

A welcome benefit of the Roth IRA is that there is no stipulated withdrawal date. As long as you are alive, you can deposit your money into the Roth IRA, let it grow and compound, and be tax-free. More importantly, any funds you choose to withdraw are tax-free.

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