Traditional IRA vs. Roth IRA – A Detailed Comparison

Traditional IRAs and Roth IRAs are the two most popular types of individual retirement accounts available. These tax-advantaged accounts are a good retirement plan option for anyone earning active income. They can help you build a secure financial future for retirement. But both traditional and Roth accounts can also be used as assets for investing. So you can Seek out CARL's sophisticated hedge fund strategies to invest in IRAs or set up your own IRA to grow your wealth for retirement.

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Traditional IRAs – “The Biggest Tax Break in History”

The Employee Retirement Income Security Act of 1974 established the financial instrument of the traditional IRA. Described as "the biggest tax break in history" for U.S. citizens, the retirement plan offers tax advantages for citizens with an active income – which is the only prerequisite they must fulfill. The greatest advantage of a traditional IRA is the tax-deductible IRA contributions. But as great as these are, they come with strict requirements regarding filing status, income, and other IRS-mandated savings plans. The IRS has laid out extensively detailed instructions on deduction and contribution limits, single and married filing, and many other cases.

Transactions such as capital gains, interest, or dividends within your traditional IRA are tax-free.

Originally called Regular IRAs, these accounts have contribution limits, but contributions aren't taxed – only withdrawals are. There are also early withdrawal penalties which typically add up to an extra 10%, on top of the income tax which you have to pay when withdrawing money.

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Contribution limits have grown over time to reflect increases in inflation. As of 2021, if you're under 50, you're allowed to put $6,000 annually into your traditional IRA. A catch-up mechanic is incorporated into the accounts for first-time investors over 50 to be able to accumulate a meaningful amount for their retirement. They are allowed an additional $1,000 per year in contributions.

Required minimum distributions (RMDs) are obligatory withdrawals that start as soon as the beneficiary of the traditional IRA turns 72. Starting on April 1st of the following year, you must make minimum withdrawals from your account – which are subject to income tax regulations in line with the beneficiary's tax bracket.

There are no income limits regulating the eligibility for traditional IRAs. But there are income limits at play for tax-deductible contributions to the account.

Roth IRA – Traditional IRA 2.0 or a Whole New Thing?

The Roth IRA, named after Senator William Roth, was part of the Taxpayer Relief Act of 1997.

It's a retirement plan which functions very similar to a traditional IRA but has a few key differences. The most important one is that withdrawals of direct contributions are tax-free and without penalty at any point in time. But contributions to a Roth IRA aren't tax-deductible, unlike those made to a traditional IRA.

Also, there are income limits for Roth IRAs. The important metric for defining those limits is the MAGI – your modified adjusted gross income. Its maximum amount depends on filing status. It's higher for married couples filing together compared to single filers. As of 2022, these are the income limits:

  • Single filing: < $129,000
  • Married filing separately: < $214,000
  • Married filing jointly: < $204,000

Keep in mind that these numbers are subject to annual changes as a reaction to possible inflation developments.

Unlike the traditional variant, the Roth IRA doesn't have the required minimum distributions. You're allowed to withdraw from your account without penalty, without paying income tax, and whenever you like.

But withdrawals from earnings work differently in a Roth account. If you're aged 59.5 or older, and you've owned your account for more than five years – also known as the "five-year rule" – you don't incur penalties or taxes. However, individuals younger than 59.5 are subject to paying penalties and taxes on withdrawing earnings from their Roth savings. Exceptions are in place for people with permanent disabilities or when using the funds towards making a first-time home purchase.

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Key Differences Between the Two Types of Individual Retirement Accounts

From a historical perspective, the Roth IRA was initially supposed to update the traditional IRA. From today's perspective, it is an alternative that you can choose for your retirement planning. CARL has compiled the key differences between the two retirement plan types in the following chart:

 Traditional IRARoth IRA
Am I required to take money from the account at a certain age?When you reach age 72, you must withdraw the required minimum distributions the following year by April 1st and every year after that.Original IRA owners don't have to take distributions, regardless of age. Other beneficiaries, however, may have to.
How does taxing distributions work?Distributions are subject to taxes as ordinary income. Non-deductible contributions may only be partly taxable.Roth IRA distributions are never taxed as long as certain criteria are met.
Is there a form I have to file for receiving distributions?Yes, form 8606 to be precise – if you have made a non-deductible contribution prior.Also, form 8606, if you have benefitted from distributions made from a Roth IRA.

The two major differences are found in the areas of taxation and contributions. Which of these fits best to your financial goals is a very personal decision that you should not make lightly. Consulting a retirement plan specialist to help you find the perfect fit is always a good idea.

Switching Between the Two Types?

If you own a traditional IRA and want to convert it entirely into a Roth IRA, you are allowed to do so, but only once.

You can withdraw the assets fully or partially and deposit them in a Roth IRA. There's a specific term for these withdrawn assets: conversion contribution. Such early withdrawals don't incur the 10 % early withdrawal penalty.

But the distribution from your traditional IRA may be – partly or fully – accounted for in your gross income, which means it is taxable income.

Recharacterization means treating an IRA contribution made to one type of account as being made to another type – the transfer must be trustee-to-trustee, though.

However, the early withdrawal penalty may apply for those withdrawal assets you don't reinvest in your new Roth IRA. Generally, those assets are also taxable. There is one exemption to that rule, though: Returns from non-deductible contributions aren't taxed. Additionally, you should keep in mind that you have a maximum of 60 days for the conversion.

Is It Possible to Own and Invest in Both Types?

The IRS hasn't formulated a rule prohibiting you from owning more than one individual retirement account. For risk-averse investors, in particular, it can be a good idea to invest in more than one of these retirement funds.

Investing in an IRA – Traditional or Roth

Investing your money in an IRA – whether it's a traditional or a Roth one – is a viable option to generate more wealth for your retirement. Unfortunately, the Internal Revenue Service has few guidelines on which investments are allowed and they remain rather vague on the subject. You are prohibited from investing in two types of traditional investments, as per IRS rules: life insurance and collectibles. The latter term sums up a couple of different types of investments, such as:

  • rugs
  • gems
  • antiques
  • art
  • coins
  • metals
  • alcoholic beverages
  • stamps

IRAs mainly allow you to invest in traditional options, such as stocks, bonds, mutual funds, and ETFs. There are a couple of exceptions for collectibles which are viable investments for IRA assets like certain types of U.S. gold coins – one, one-tenth, one-quarter, and one-half ounce ones from the Treasury Department's minting. Certain bullions made of platinum, palladium, silver, and gold can also be invested in. To invest in many high-yielding alternative investment opportunities, you should consider turning your IRA into a self-directed IRA.

    CARL provides you with highly liquid quant hedge fund strategies that offer 15%+ targeted returns, as well as self-directed IRAs. There are various strategies available for accredited investors to choose from. Whether it be a long or short-term, higher risk and higher return or lower-risk, lower-return strategy – you can choose whichever one fits your portfolio and suits your financial goals.

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    Traditional vs. Roth IRA – Which Is Better?

    There is no clear answer to this question, depending on your filing status, income, and general financial prosperity. Both variants offer significant advantages. A Roth IRA is more beneficial for investing, though, as earnings made from it can be withdrawn penalty- and tax-free. No matter which type of IRA you're interested in, you'll find self-directed IRAs as well as sophisticated quant hedge fund strategies at CARL. Invest today to make sure you're financially stable in the future.

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    Introducing CARL Self Directed IRA

    The CARL Self Directed IRA is now live on the CARL app. Listen to this podcast episode where John Bowens from Equity Trust, our partner in this offering, and Jamie Uppenberg from CARL talk about self-directed IRAs and the benefits of alternative investments like the hedge funds available with CARL.

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