IRA Insights: Roth vs. Traditional

Retirement is one event most of us will experience, and the reason why so many of us participate in a retirement plan (or plans) of some kind. While Social Security benefits remain the largest source of income for most retirees, employer-sponsored retirement plans and individual retirement accounts (IRAs) – both traditional and Roth IRAs – take on increased importance for people whose Social Security benefits replace a smaller share of their earnings.

Although traditional IRAs and Roth IRAs work similarly, if you haven’t considered a Roth IRA as part of your overall retirement planning, now may be a good time to evaluate opening a Roth IRA or converting a traditional IRA into a Roth IRA. The chart below provides a quick side-by-side comparison.

*Penalties do not apply for the following: Unreimbursed medical expenses (must be more than 10% of adjusted gross income); health insurance premiums while unemployed (must have received unemployment compensation for 12 consecutive weeks); permanent disability and inability to work; higher education expenses for owner, spouse, children, or beneficiary; inherited IRAs are not subject to withdrawal penalties – unless you are the spouse and roll the funds over to your own IRA (in which case the early withdrawal rules apply); buying, building, or rebuilding your own home for the first time (“first time” meaning you have not owned a home in the previous two years); Substantially Equal Periodic Payments (SEPP) or regularly withdrawn amounts over a period of five years, by pre-approved methods determined by the IRS; to pay an IRS levy on back taxes (no penalty on the IRA withdrawal if the IRS takes the money directly from the account; qualified reservist distributions for military reservists or National Guard members.

The biggest difference? How contributions and withdrawals are taxed.  

• With a Roth IRA, you make after-tax contributions. Not only will your money grow tax-free, but you also won’t have to pay taxes on qualified withdrawals when you retire.
• With a traditional IRA, your contributions could be tax deductible. That means you can deduct contributions on your annual tax return, which lowers your current taxable income. But since you’re not paying taxes on contributions, you’ll have to pay taxes on that money and its growth when you take withdrawals in retirement.

Withdrawal differences between the Roth and traditional IRA

Generally, you want to avoid taking withdrawals from any IRA before age 59½ (unless one of the exceptions above applies to you) to avoid the 10% early withdrawal penalty. When you withdraw money from your traditional IRA after you turn 59½, you’ll pay taxes on the withdrawal at your ordinary income rate. With Roth IRAs, your withdrawals are completely tax-free. And when it comes to Required Minimum Distributions (RMDs), there are also some key differences:

• With a Roth IRA, you’ve already paid taxes on your contributions. You can leave the funds in your account to keep growing tax-free throughout your lifetime – with NO RMDs.
• With a traditional IRA, you must start taking RMDs when you turn 73 (or 75 for those born after January 1, 1960) and you will owe taxes on the RMDs at your income tax rate.¹

How Roth IRAs can benefit your estate plan

As mentioned, funds in a Roth IRA can come out tax-free. This makes Roth IRAs a great vehicle for passing on wealth to your heirs, giving them tax-free income that can be stretched over ten years after your passing. Even though your beneficiaries will have to take RMDs after your passing, they will not be subject to income tax from Roth IRA distributions. This allows your beneficiaries to enjoy the benefits of having the assets grow tax-free, while not having to pay taxes on distributions they take.

What if you haven’t taken full advantage of the Roth IRA?

You may still have options with a Roth IRA conversion – the process of transferring funds from a traditional IRA into a Roth IRA. A Roth IRA conversion may be an ideal option if you can’t contribute to a Roth IRA because your income exceeds the limits set by the IRS. This conversion is treated as a taxable distribution (since you’re taking money out of a tax-deferred account), so it’s important to talk to your advisor and tax professional about how this event will impact your taxes before you decide to make the move.

What has changed in recent years?

The Setting Every Community Up for Retirement Enhancement (SECURE) Act, signed into law in 2019, made some key changes to traditional and Roth IRAs:

• Age limits for traditional IRA contributions. Individuals of any age can contribute to a traditional IRA if they have earned income.
• RMDs. The age for starting RMDs from a traditional IRA increased from 70 ½ to 72. Secure 2.0, passed in 2022, increased the RMD distribution age to 73 as of January 2, 2023. However, if you turned 72 in 2022, you had to take your first RMD by April 1, 2023. In 2033, the RMD age will change again from 73 to 75.
• 10-year rule for beneficiaries of inherited IRAs. Most non-spouse beneficiaries must empty the account within 10 years of the account owner’s death.

Both Roth and traditional IRAs are excellent ways to save for retirement, either alongside a workplace retirement plan or on their own. For more information on Roth and traditional IRAs, or to see how the SECURE Act may have impacted your financial or estate plan, speak with your advisor. And if you are not a Mercer Advisors client, let’s talk.

¹ Internal Revenue Service. “Retirement Topics – Required Minimum Distributions (RMDs).” Internal Revenue Service, 2 May 2024.