Rollover IRA vs. Roth IRA

Attribute	Rollover IRA	Roth IRA
Tax Treatment	Tax-deferred growth, taxable withdrawals	Tax-free growth, tax-free qualified withdrawals
Contributions	Contributions can be made from rollovers or transfers	Contributions are made with after-tax dollars
Income Limits	No income limits for contributions	Income limits apply for contributions
Withdrawals	Withdrawals before age 59½ may incur a 10% penalty	Qualified withdrawals can be made tax-free after age 59½
Required Minimum Distributions (RMDs)	RMDs are required starting at age 72	No RMDs during the original account holder's lifetime
Conversion	Can convert from a Traditional IRA or employer-sponsored plan	Can convert from a Traditional IRA or employer-sponsored plan

Introduction

Individual Retirement Accounts (IRAs) are popular investment vehicles that offer tax advantages for retirement savings. Two common types of IRAs are Rollover IRAs and Roth IRAs. While both serve the purpose of helping individuals save for retirement, they have distinct attributes that make them suitable for different financial situations and goals. In this article, we will compare the attributes of Rollover IRAs and Roth IRAs to help you make an informed decision about which one may be the right choice for you.

Tax Treatment

One of the key differences between Rollover IRAs and Roth IRAs lies in their tax treatment. Rollover IRAs are typically funded with pre-tax dollars, meaning that contributions are tax-deductible in the year they are made. However, withdrawals from Rollover IRAs are subject to ordinary income tax rates at the time of distribution. On the other hand, Roth IRAs are funded with after-tax dollars, so contributions are not tax-deductible. However, qualified withdrawals from Roth IRAs are tax-free, including both contributions and earnings. This tax-free growth potential can be a significant advantage for individuals who expect to be in a higher tax bracket during retirement.

Income Eligibility

Another important factor to consider when choosing between a Rollover IRA and a Roth IRA is income eligibility. Rollover IRAs do not have income limits, meaning that anyone can contribute regardless of their income level. This makes Rollover IRAs a suitable option for high-income earners who may not be eligible for a Roth IRA. On the other hand, Roth IRAs have income limits that determine eligibility. For the tax year 2021, single filers with a modified adjusted gross income (MAGI) above $140,000 and married couples filing jointly with a MAGI above $208,000 are not eligible to contribute to a Roth IRA. However, there is a workaround known as a "backdoor Roth IRA" that allows high-income earners to contribute indirectly by making non-deductible contributions to a traditional IRA and then converting it to a Roth IRA.

Required Minimum Distributions (RMDs)

One aspect that differentiates Rollover IRAs from Roth IRAs is the requirement for minimum distributions. Rollover IRAs are subject to Required Minimum Distributions (RMDs) starting at age 72, as mandated by the IRS. These distributions are taxable and must be taken annually to avoid penalties. On the other hand, Roth IRAs do not have RMDs during the account owner's lifetime. This feature can be advantageous for individuals who do not need to rely on their retirement savings immediately and want to continue growing their investments tax-free for as long as possible.

Early Withdrawal Penalties

Both Rollover IRAs and Roth IRAs have penalties for early withdrawals, but the rules differ. With a Rollover IRA, if you withdraw funds before the age of 59½, you may be subject to a 10% early withdrawal penalty in addition to ordinary income taxes. However, there are certain exceptions to this penalty, such as using the funds for qualified higher education expenses or a first-time home purchase. On the other hand, Roth IRAs have more flexibility when it comes to early withdrawals. Contributions to a Roth IRA can be withdrawn at any time without taxes or penalties since they have already been taxed. Additionally, qualified distributions of earnings from a Roth IRA can be withdrawn tax-free and penalty-free if the account has been open for at least five years and the account owner is over 59½, disabled, or using the funds for a first-time home purchase.

Conversion Options

One advantage of a Rollover IRA is the option to convert it to a Roth IRA through a process known as a Roth conversion. This allows individuals to take advantage of the tax-free growth potential of a Roth IRA by paying taxes on the converted amount at the time of conversion. However, it's important to note that the converted amount is considered taxable income in the year of conversion. This strategy can be beneficial for individuals who expect their tax rate to be lower at the time of conversion compared to their projected tax rate during retirement. On the other hand, Roth IRAs cannot be converted to Rollover IRAs.

Contributions and Limits

Both Rollover IRAs and Roth IRAs have contribution limits set by the IRS. For the tax year 2021, the maximum annual contribution limit for both types of IRAs is $6,000 for individuals under 50 years old and $7,000 for individuals aged 50 and older. However, it's important to note that these limits apply to the combined contributions to both types of IRAs. For example, if you contribute $3,000 to a Rollover IRA, you can only contribute up to $3,000 to a Roth IRA in the same tax year. It's also worth mentioning that Rollover IRAs can be funded through rollovers from employer-sponsored retirement plans, such as 401(k)s, while Roth IRAs can only be funded with cash contributions.

Conclusion

In summary, Rollover IRAs and Roth IRAs have distinct attributes that make them suitable for different financial situations and goals. Rollover IRAs offer immediate tax benefits through tax-deductible contributions, but withdrawals are subject to ordinary income tax rates. Roth IRAs, on the other hand, do not provide upfront tax deductions, but qualified withdrawals are tax-free. Income eligibility, required minimum distributions, early withdrawal penalties, conversion options, and contribution limits are additional factors to consider when choosing between the two. Ultimately, the decision between a Rollover IRA and a Roth IRA depends on individual circumstances, financial goals, and tax planning strategies. It's advisable to consult with a financial advisor or tax professional to determine the best option for your specific needs.