Finance Tips

2023 IRA Guide: Deciding Between Traditional and Roth

Andy Lim

Feb 6, 2023 • 5 min read

Individual Retirement Accounts (IRAs) come in many different shapes and sizes but the most common ones you will find are traditional IRAs and Roth IRAs. IRAs are a great way to take advantage of your savings for retirement so it is important to understand how they work and if they can be a good addition to your financial portfolio.

How Do IRAs Work?

IRAs are investment accounts that offer tax benefits in exchange for holding off withdrawals until age 59½. You can invest your money like any other brokerage account. But if you withdraw from your IRA before age 59½, then your withdrawal is subject to being included in gross income (which increases your income taxes) plus a 10 percent additional tax penalty.

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10 percent is a significant penalty so it's important to only contribute to an IRA with money you want to reserve for retirement.

The benefits of an IRA slightly different per IRA type, but one benefit they all share is that your money in the account can grow tax free. This means any interest you earned on the account or capital gains you made on the account for the year are not included in your gross income for annual tax reporting. You will not have to pay taxes on your earned money as long as that money stays in the IRA.

Traditional IRAs

When it comes to the traditional vs Roth IRAs, the difference comes down to what you can contribute with (pre-tax or after-tax dollars) and how withdrawals work.

You can contribute pre-tax and after-tax dollars to traditional IRAs. If you contribute pre-tax dollars, you can get a tax deduction for it. Pre-tax dollars can seem a bit convoluted, but it's your gross dollars earned before you pay any taxes to the IRS. If you receive money via paycheck, the paycheck provider will typically take out taxes before the money lands in your bank account. When your paycheck provider takes out money for taxes, the remaining money is considered after-tax dollars. Prior to that event, it's considered pre-tax dollars. The most common way to get pre-tax dollars into a traditional IRA is to have your paycheck provider take out part of your untaxed income to your traditional IRA before taxes are applied. If you operate a business where you receive your money directly (no middleman provider taking taxes out on your behalf), then you can also contribute directly to a traditional IRA.

For a traditional IRA, when you withdraw from your traditional IRA after age 59½, your withdrawn amount will be included as part of your gross income. You will pay taxes accordingly based on your tax bracket like any other year. On paper, it seems no different than a brokerage account. But the key difference in the traditional IRA is all the years where you did not have to include your gains for taxes. Here are some scenarios to consider:

Scenario	Recommended Account	Justification
Account consists mostly of money market funds or dividend paying funds/stocks	Traditional IRA	The interest you get from money market funds and dividends can compound better when they are not subject to taxes each year.
Account consists mostly of growth funds or stock and you do trade	Traditional IRA	If you plan on selling your stocks for profits occasionally, then you can use the traditional IRA to protect your profits from being subject to taxes every year. All the money you gain can be used for your next transaction.
Account consists mostly of growth funds or stocks and you do NOT trade	Brokerage account	If majority of your account does not pay dividends or yield interest, AND you do not trade for short term profits occasionally, then there's no benefit of a traditional IRA because your gains aren't realized (thus subject to taxes) until you sell. You won't end up needing to pay much taxes since you don't earn much money each tax year.

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The above scenarios have been simplified for reading purposes. Please consult a real financial advisor (I am not one) for any investment advice. Please also talk to a real CPA (I am not one) for your specific tax situation.

Roth IRAs

For a Roth IRA, contributions can only be made with after-tax dollars (pre-tax dollars are not allowed). There are two main advantages of a Roth IRA over a traditional IRA:

You can withdraw your contributions at ANY time (even before 59½) tax-free and penalty free
Upon reaching age 59½, withdrawals from a Roth IRA are also excluded from gross income, allowing you to retain their full savings without incurring any tax liability

IRA Eligibility

In order to start contributing to an IRA, you must first check if you are eligible. Fortunately, it's a somewhat simple check. For traditional IRAs, you just need to have taxable compensation. For Roth IRAs, you need to have taxable compensation and your Modified Adjusted Gross Income (MAGI) must be below a certain amount. There are no hard age requirements or age limits for IRAs. The only thing that your age affects is your max possible contribution limit.

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Taxable compensation is a very specific term used by the IRS. The details can be found on their publication here in the section titled What Is Compensation?. Generally speaking, if you work and get a paycheck, then you have taxable compensation. The specifics matter more if you earn money in less conventional ways. Please consult with a CPA if you are not sure.

Contribution Limits

IRAs provide significant tax advantages for growing your money. Because of this, there are limits on how much you can contribute to IRAs. Here are the current contributions limits:

2023 Contribution Limits

Year	Age	IRA contribution limit
2023	49 years old or younger	$6,500
2023	50 years old or older	$7,500

2022 Contribution Limits

Year	Age	IRA contribution limit
2022	49 years old or younger	$6,000
2022	50 years old or older	$7,000

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You can make IRA contributions for 2022 until April 18, 2023.

The IRA contribution limit applies to all IRA accounts under your name (yes, you can have multiple IRA accounts on many different platforms). This means if you contribute $6,500 to a traditional IRA (in 2023), you can no longer contribute to a Roth IRA and vice versa. If you contribute $3,000 to a traditional IRA (in 2023), then that means you can only contribute up to $3,500 in your Roth IRA. The total contributions across all your IRA accounts must be no greater than the limit.

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In some unconventional cases where you have multiple IRA accounts of the same type, this also applies. Let's say you had two Roth IRA accounts. This means if you have contributed $2,000 to your first Roth IRA account, then you can only contribute up to $4,000 in your second Roth IRA account. I recommend trying to keep everything in one place to make it easier (especially when it comes to tax reporting).

Final Thoughts

IRAs are good for saving for retirement because they offer tax benefits and can help grow your savings faster than a regular savings account or a brokerage account. Traditional IRAs are better for those who expect their tax burden to be less in retirement and could use more tax deductions. Roth IRAs are better for those who don't want to deal with taxes at all in retirement and might want to claw back their contributions for emergencies.

Keep in mind that for Roth IRAs, there is an income limit. But fortunately, there is a way to get around that called Backdoor Roth (will cover in a future post!).

Before you make a move on IRAs however, please only consider IRAs if you have already considered the following:

Emergency Funds in High Yield Savings Account (HYSA)
401k (if employer does contribution matching)

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