Both are related entirely to taxes. Both are related to IRA’s (Individual Retirement Accounts). It’s all about how your money is taxed. Is it taxed when you put your money in (now)? Or when you withdraw it later in life (retirement)?

When you open up an IRA at Vanguard you have to choose either “Traditional” or “Roth”.

Inside of the IRA is where you choose what to invest in. (Stock index, bond index, etc). See Asset Allocation page for that. This page is all about Traditional vs Roth and the important differences between the two.

As always, it depends on your individual situation.

Biggest difference between Roth and Traditional is how and when you get a tax break.

• Traditional – your contributions are tax deductible in the year they are made (tax break now)
• Roth – your withdrawals in retirement are not taxed (tax break later)

Most advice on the Roth vs Traditional starts with, do you think your tax rate will be higher or lower in the future?

If you think your tax rate will be higher when you’re older (most people do because you make more money as you get older) then you will want the Roth. (Because you pay taxes on the money now when you’re in a lower bracket.)

There is some certain criteria you must meet in order to invest in a Traditional or Roth IRA. There is also limits on how much you can invest in one year.

• For 2019, Traditional and/or Roth you can contribute up to $6,000, or $7,000 if your 50 or older.

But in order to contribute that $6,000 there are a few small rules you must pass.

To understand these tables you need to know what Modified AGI is. Modified Adjusted Gross Income. Basically, how much income you made for the year plus or minus some tax deductions.

Your Adjusted Gross Income is what determines what tax credits and exemptions you are eligible for at the end of the tax year. Many deductions phase out if your AGI is above a certain threshold.

AGI Calculation

Your AGI (Adjusted Gross Income) is all the income you bring in, LESS certain adjustments. Some common adjustments to AGI are:

• IRA and self-employed retirement plan contributions
• Alimony payments (divorce agreements prior to 2019)
• Self-employed health insurance payments
• One-half of any self-employment taxes paid
• Heath savings accounts
• Penalties on the early withdrawal of savings
• Educator expenses
• Student loan interest
• Moving expenses (for tax years prior to 2018)
• Tuition and fees
• Deductions for domestic production activities (for tax years prior to 2018)
• Certain business expenses of performing artists, reservists, and fee-based government officials

So, your AGI is your income minus any of those deductions listed above. So for tax purposes, you take your total income, minus some of those adjustments, and that is your “income” that gets taxed. So it’s good that some of those things can lower your “income” for tax purposes.

Your MAGI (modified adjusted gross income) is your income but ADDING many of those things back in.

• Student loan interest
• One-half of self-employment tax
• Qualified tuition expenses
• Tuition and fees deduction
• Passive loss or passive income
• IRA contributions, taxable social security payments
• The exclusion for income from U.S. savings bonds
• The exclusion under 137 for adoption expenses
• Rental losses
• Any overall loss from a publicly traded partnership

So, basically your MAGI is all your income, without taking any deductions. It’s very possible that your AGI and MAGI are close in number as many deductions may not apply.

So when looking at the above tables, we are talking about MAGI. So basically ALL your income, without taking any deductions.

Key point: You can contribute to both a Roth IRA and a Traditional IRA during the year. Just as long as the total amount doesn’t go over the limit. In 2019 the limit is $6,000. That is Roth and Traditional combined!

• Roth has a big benefit that you can withdraw ANY of your CONTRIBUTIONS at any time without having to pay taxes or a early withdrawal penalty
• Traditional, you have to pay a 10% early withdrawal penalty and owe taxes at your current income rate if you withdraw any money. Including your contributions! There are a few exceptions to this rule, discussed later.

• Traditional IRA’s require you to start taking required minimum distributions (RMD) at age 70.5
• Roth IRA has no required minimum distribution rules
• Also, Traditional stops you from making any more contributions once you hit 70.5. However, Roth allows you to keep putting money in, as long as you meet the qualifications. So Roth makes it easier to save money to pass on to your heirs if you still have money to save when you’re older.

Summary

• Both types of IRA’s you pay no taxes whatsoever on all the growth of your contributed funds, as long as they remain in the account
• Both Traditional and Roth allow owners to begin taking penalty free “qualified” distributions at age 59.5.

Traditional IRA Benefits

• Contributions to Traditional IRA’s generally lower your taxable income, which lowers your Adjusted Gross Income (AGI), thus helping you qualify for other tax incentives (note: if you spouse has a retirement plan at work, the tax deduction is reduced – see tables above)
• If you are under age 59.5, you can withdraw up to $10,000 from you account without the normal 10% early withdrawal penalry to pay for a qualified first time home-buyer expenses and for qualified higher education expenses. Other exemptions are listed below. However, you still pay taxes on the early withdrawal.

Roth IRA Benefits

• Roth contributions (not earnings) can be withdrawn penalty free and any time before age 59.5
• If you are under 59.5 you can withdraw up to $10,000 of Roth earnings penalty-free to pay for qualified first time home-buyer expenses, as long as your initial contributions have been in the Roth for 5 years

Important questions to ask yourself:

• Which federal tax bracket are you in today?
• Do you expect to be in a higher or lower one when you retire?
• Will your annual income increase or decrease?

Exceptions to avoid the 10% penalty on early withdrawals before 59.5. Note: you still pay income taxes on the early withdrawals.

• Qualified higher education expenses
  • Pay for higher education expenses for yourself, or immediate family members (spouse, children, grandchildren)
  • There is no dollar limit, and expenses that fall under this rule include: Tuition, fees, books, and supplies. Room and board is allowed for students who are attending more than half time
• Home Purchase
  •  Can withdraw up to $10,000 for purchase of your first home, and if you’re purchasing with a spouse, that goes for each of you.
  • First time home buyer just means you or your spouse haven’t owned a principal residence in the last two years. You must use the money within 120 days of the distribution.
• Medical Expenses and health insurance premiums
  • To pay for unreimbursed medical expenses that exceed 7.5% of your adjusted gross income, or to pay for health insurance premiums for you, spouse, or children when you are unemployed.
    • You make $100,000 and have $15,000 of unreimbursed medical costs, you can use IRA money to pay for $7,500 of it.
    •  For health insurance premiums while unemployed, you must take the distributions no more than 60 days after you’ve gotten a new job
• Substantially equal payments
  • You can avoid the 10% penalty by taking a set distribution from your IRA that is spread out equally over your life expectancy or the life expectancies of you and your beneficiaries.
  • Note: You can’t modify this schedule until five years have passed or you’ve reached age 59.5, whichever is later
  • The amount of the distributions but be based on an IRS-approved calculation that involves your life expectancy, your account balance, and interest rates
  • So scenario would be if you wanted to start taking some money out before 59.5 say for health reasons or something, you could do it at a set equal rate, that can’t be changed.
• Qualified Reservist Distributions
  • If you’re in the military and you are called to active duty for more than 179 days, you can take a penalty free distribution from your IRA
  • Must be made during period of active duty
• Death or total and permanent disability
  • If you become disabled, you can tap your traditional IRA funds without penalty. If you die, your beneficiaries or estate can withdraw tax free

A backdoor Roth IRA lets you convert your traditional IRA to a Roth, even if your income is too high to open a Roth the regular way. (see MAGI table)

It’s a way for people with high incomes to sidestep the Roth’s income limit.

Simple summary: Put money in a Traditional IRA, convert it to Roth, pay some taxes, and boom now you have a Roth.

Why do this?

• Mainly because the money grows tax free.
• Key note: High income earners can’t contribute to Roth IRA’s. So it’s kind of a one-time thing

Steps

1. Put money into a traditional IRA account
2. Convert the account to Roth IRA. Do the paperwork.
3. Prepare to pay taxes on the contributions to your traditional IRA. Only post-tax dollars go into Roth IRA’s. So if you deducted your traditional IRA contributions and then decide to convert to a Roth, you’ll need to give that tax deduction back. When you have to file taxes, be prepared to pay income tax on the money you converted to a Roth
4. Prepare to pay taxes on the gains in your traditional IRA. If your traditional IRA has been sitting there awhile, and you have investments gains, you’ll also owe taxes on those gains.

Rules:
To avoid penalties, conversation has to be one these:

1.  A rollover, where you receive money from you IRA and deposit it into the Roth within 60 days
2.  A trustee-to-trustee transfer where the IRA provider sends the money directly to your Roth IRA provider
3. A same-trustee transfer, where your money goes from the IRA to the Roth at the same financial institution

When not to do it:

• If the only way you can pay the taxes due is with money from your IRA withdrawal. You’re taking money away that will grow, and if you’re under 59.5 you’ll owe the 10% early withdrawal penalty on that money
• If you need the money within 5 years or less. Roth’s require money to sit for 5 years before it can be withdrawn without penalty
• The withdrawal from the IRA pushes you to the higher income tax bracket. It’s advised to only convert enough that you’re not pushed into paying a higher tax rate that year.

Sources:

https://www.nerdwallet.com/article/roth-or-traditional-ira-account
https://turbotax.intuit.com/tax-tips/irs-tax-return/what-is-the-difference-between-agi-and-magi-on-your-taxes/L7kHckNS3
https://www.rothira.com/traditional-ira-vs-roth-ira
https://investor.vanguard.com/ira/roth-vs-traditional-ira