What’s the Difference Between Roth & Traditional IRAs?

Whether you’re opening an individual retirement account (IRA) for the first time or just looking to expand your portfolio, you may be wondering whether a traditional vs. Roth IRA is right for you.

So to help you choose, we’re looking at the difference between Roth and traditional IRAs. 

TL;DR:

• Traditional IRAs are tax-deferred, meaning you won’t pay taxes on your gains until you take a distribution.
• Roth IRAs are completely tax-free because contributions are made using post-tax funds.
• To enjoy the tax advantages that IRAs offer, you must wait until turning 59-½ to take distributions (plus have your account for at least five years in the case of a Roth IRA).

Traditional vs. Roth IRA: Which Is Better?

The truth is that there’s no right answer. Both traditional and Roth IRAs have their own benefits, and what’s right for you may not be right for someone else. There are also no rules about how many IRAs you can have. As a result, many investors have both for different reasons.

Open to anyone earning an income, an IRA is a tax-savvy way to invest for your future, with the two most common types being traditional and Roth IRAs.

Both provide special, albeit-different tax advantages provided you wait until at least six months after turning 59 to make a withdrawal. Additionally, you must have your Roth IRA for at least five years before taking withdrawals or you’ll incur a tax penalty.

The Benefits of a Traditional IRA

IRAs were created by Congress in the 1970s to incentivize investing for retirement through tax-deferred contributions. This was in response to many companies eliminating pension plans and growing fears that Social Security would run out—a concern that appears increasingly likely.

The idea was that by allowing individuals to make pre-tax contributions, they could afford to invest more upfront, giving their investments more time to grow. Instead, investors would pay income taxes upon taking distributions—when they might find themselves in a lower tax bracket (say, if no longer earning a salary).

Likewise, IRA holders were encouraged to give their investments time to grow by imposing penalties on early withdrawals. While traditional IRA account holders are not required to take distributions at 59-½, they must begin taking required minimum distributions (RMDs) once they turn 73 (as of 2023).

Why Choose a Traditional IRA?

A traditional IRA can be a good choice for investors who:

• Have limited income to invest but want to put aside as much as they can now
• Anticipate being in a lower tax bracket when distributions are taken
• Want to show less taxable income for the current tax year
• Aren’t eligible to contribute to a Roth IRA

Read more: Are IRA Contributions Tax-Deductible?

The Benefits of a Roth IRA

By the 1990s, a lot of people still weren’t taking advantage of IRAs. Concerned that many Americans would not have enough to retire, Congress again took action. This time creating the Roth IRA, which offers a potentially greater perk: Completely tax-free gains and distributions for those who are eligible. 

Unlike traditional IRAs, not everyone can contribute to a Roth IRA. Congress, seeing Roth IRAs as a means for ultra-wealthy individuals to shield their income from taxes, felt it necessary to impose income limits on who could make contributions to a Roth IRA. Despite this, anyone can fund a Roth IRA account via what’s called a backdoor Roth conversion, though it will include a one-time tax penalty (more on that later).

Roth IRAs share the same contribution limits as traditional IRAs, but contributions are made using after-tax money. As a result, withdrawals are completely tax-free as long as your account is at least five years old and you wait until six months after turning 59 to take any distributions. Additionally, unlike with traditional IRAs, Roth IRA holders are not required to take RMDs.

Finally, Roth IRAs offer another unique advantage: You can withdraw your contributions (not gains) at any time without penalty. 

Why Choose a Roth IRA?

Though not everyone can make contributions, Roth IRAs can be great for people who:

• Expect their investments to grow considerably (which could amount to a sizable tax bill with a traditional IRA or in a brokerage account)
• Would rather pay taxes up front so it’s not a concern later on
• Believe income taxes will be higher when they become eligible to take distributions
• Anticipate being in a higher tax bracket when they go to take distributions (for example, because they are still working and have a higher income job)
• Foresee a situation where they might need to tap into your contributions to cover an immediate expense
• Don’t want to begin taking required minimum distributions
• Hope to leave their Roth IRA to a child or other beneficiary

Traditional and Roth IRA Contributions and Restrictions

Of course, no discussion of IRAs would be complete without talking about contribution limits.

For the 2023 tax year, both traditional and Roth IRA account holders can contribute up to $6,500 per year, with an extra $1,000 “catch up” contribution allowed for people 50 and older.

Unlike with traditional IRAs, however, there are income-based restrictions for who can contribute to a Roth IRA. Per the 2023 Internal Revenue Service (IRS) guidelines, the following are ineligible to contribute to a Roth IRA:

• Individual filers with an annual income of $153,00 or more
• Joint filers with an annual income of at least $228,000

Additionally, people in certain income ranges are eligible to make reduced contributions:

• Individual filers earning between $138,000–$152,999.99 annually
• Joint filers earning between $218,000–$227,999.99 annually

There are, however, ways to fund a new Roth IRA account even if your income exceeds the IRS limits.

Read more: Am I Eligible for a Roth IRA?

Other Ways to Fund Your IRA

IRAs can also be funded by rolling over another IRA or other retirement account, such as a 401(k) or 403(b) from a previous employer. Rollovers do not count toward the annual contribution limit. 

When rolling funds between like accounts, you won’t pay a tax penalty as long as you follow the rules for doing so. Examples include rolling a traditional 401(k) into a traditional IRA or funds from one Roth IRA to a new Roth IRA. 

However, it’s also possible to roll a traditional, tax-deferred retirement account into a tax-free Roth IRA by paying taxes on the transfer. 

Read more: What Is a Backdoor Roth IRA?

Using an IRA to Invest in Alternative Assets

Now here’s what you might not know about traditional or Roth IRAs… you can invest in a lot more than just stocks, bonds, and mutual funds. 

Typically, IRA custodians offer the same limited investment opportunities as found in employer-provided 401(k) accounts. Typically, these amount to a handful of options based on your tolerance for risk and anticipated distribution date, and consist of public equities. 

What many people don’t know is that you can also use your IRA to invest in non-traditional assets. 

With a traditional or Roth self-directed IRA, you can invest in a variety of private offerings and other alternative asset classes, including:

• Commercial and residential real estate
• Cryptocurrencies
• Farmland and other land rights
• Music royalties and publishing rights
• Securitized artworks and other collectibles
• Startups and pre-IPO companies

Because many of these assets are not strongly correlated with the stock market, a self-directed IRA is a terrific way to diversify your portfolio beyond the increasingly outdated 60/40 model of just stocks and bonds. And because many investors have a long time horizon prior to withdrawing their retirement funds, they make a good fit for alternative investments, which tend to be illiquid until maturity.

Invest in Alternatives with a Traditional or Roth Alto Account

Whether a traditional vs. Roth IRA is right for you, both offer considerable advantages over taxable investment accounts. For this reason, many investors have both.

IRAs also give you greater flexibility by enabling you to invest in alternative assets, making self-directed IRAs an increasingly popular vehicle for investors looking to add greater diversification to their portfolios.

If you’re interested in using tax-advantaged retirement account funds to invest in non-traditional assets, a self-directed IRA from Alto may be what you’re looking for. 

• Alto IRA enables accredited and non-accredited investors alike to invest in alternatives through a wide variety of investment platform partners, like AngelList, FarmTogether, and Masterworks.
• Alto CryptoIRA^® lets you buy and sell up to 200+ crypto assets with low investment minimums, no monthly account fees, and integration with Coinbase.

Open an Alto account today to discover the advantages of a traditional or Roth self-directed IRA.

Originally published November 24, 2021