If you’re opening an individual retirement account (IRA) for the first time, you may be wondering which is better, a traditional vs. a Roth IRA?
The truth is each has its 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, and some people have both for different reasons.
To help you choose, we’re looking at the differences of a Roth IRA vs. a traditional IRA.
Roth and Traditional IRAs Both Offer Unique (Tax) Advantages
Open to anyone earning an income, an individual retirement account (IRA) is a tax-savvy way to invest for your future, with the two most common being traditional and Roth IRAs.
Both provide special tax advantages to account holders provided you wait until at least six months after turning 59 to make a withdrawal. (As you’ll find out later in this post, there are additional rules for Roth IRAs.)
Typically, IRAs are managed by a custodian and offer limited investment options in the same way that many employer-provided 401(k) accounts offer just a handful of options limited based on your tolerance for risk and anticipated distribution date. However, what many people don’t know is that you can also use an 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
- Farmland and other land rights
- Music royalties and publishing rights
- Securitized artworks and other collectibles
- Shares of investment-grade wines and spirits
- 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with the stock market, a self-directed IRA is a terrific way to diversify your portfolio beyond the increasingly outdated 60/40 model of just stocks and bonds.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 you can’t withdraw from an IRA penalty-free at just any time, they make a good fit for alternative investments, which tend to take longer to mature.
Before jumping into a comparison of Roth vs. traditional IRAs, it’s helpful to understand IRA contribution limits.
Traditional and Roth IRA Contribution Limits
As with other tax-advantaged retirement investments, IRAs are subject to contribution limits. Currently, traditional and Roth IRA account holders can contribute up to $6,000 per year, with an extra $1,000 “catch up” contribution allowed for people 50 and older.
Unlike with traditional IRAs, there are income-based restrictions for who can contribute to a Roth IRA. Per the 2022 Internal Revenue Service (IRS) guidelines, the following are ineligible to contribute to a Roth IRA:
- Individual filers with an annual income of $144,000 or more
- Joint filers with an annual income of at least $214,000
Additionally, people in certain income ranges are eligible to make reduced contributions:
- Individual filers earning between $129,000 and $143,999.99 annually
- Joint filers earning between $204,000 and $213,999.99 annually
There are, however, ways to fund a new Roth IRA account even if your income exceeds the IRS limits.
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. (To learn more about this popular investment strategy, read our blog post on backdoor Roth IRAs.)
Now that we have a better idea of what IRAs can be invested in, how IRA contribution limits work, and other methods of funding an IRA, we can jump into the advantages each offers.
The Benefits of a Traditional IRA
IRAs were created by Congress in the 1970s to incentivize investing for retirement through tax-deferred contributions. At the time, fewer and fewer companies were offering pensions and the alarm was already being sounded 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 generate returns by imposing penalties on withdrawals made prior to six months after turning 59. Keep in mind that traditional IRA account holders are not required to take distributions until turning 72.
To recap the advantages of a traditional IRA, these tax-deferred investment accounts 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
The Benefits of a Roth IRA
By the 1990s, a lot of people still weren’t using IRAs to invest for the future. So Congress created the Roth IRA, which offers a potentially greater perk: completely tax-free gains and distributions for those who are eligible.
In fact, it was to prevent the ultra-wealthy from using Roth IRAs to shield their income from taxes that Congress imposed limits on who could contribute to a Roth IRA.
Roth IRAs have 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 your first distribution. Also, Roth IRA holders are not required to take RMDs.
Though contributions are not available to everyone, there are many benefits to a Roth IRA, making them great for people who:
- Expect their investments to grow considerably
- Never want to pay taxes on their investments
- Believe income taxes will be higher when eligible to take distributions
- Anticipate being in a higher tax bracket when they go to take distributions
- Don’t want to begin taking distributions at age 72
Use Your Traditional or Roth IRA to Invest in Crypto and Other Alts
Whether a Roth or traditional IRA is right for you, both offer considerable advantages over taxable investment accounts. For this reason, many investors have both traditional and Roth IRA accounts.
If you’re interested in using tax-advantaged retirement funds to invest in non-traditional assets, a self-directed IRA from Alto may be what you’re looking for.
Alto offers two different IRAs, both of which are available as traditional, Roth, or Simplified Employee Pension (SEP) IRAs:
- Alto IRA makes it easy for accredited and non-accredited investors alike to invest in alternative assets through more than 80 partnerships. Examples include AngelList, Masterworks, Grayscale, Fundr, Vint, and more. You can even bring your own investment deal to the table.
- Alto CryptoIRA® lets you buy, sell, and trade more than 150 different crypto assets with $10 investment minimums, no monthly account fees, a low 1% trading fee, market and limit orders, and integration with Coinbase—one of the largest cryptocurrency exchanges in the world.
Ready to start investing with a traditional or Roth self-directed IRA, open an Alto account today!