Roth vs. Traditional IRA - which should I choose?
True story. My first job offered both a Roth and a Traditional option for a retirement plan. I had no idea what that meant but remember hearing that diversity was good. So I put half of my money in each. I did the same thing with the investment options. 5% going to each of the 20 investment options. My retirement portfolio had a lot going on, to say the least.
We don’t learn about this stuff and then we’re faced with choices that will make a big difference in our financial future. It makes sense that one of the most common questions I get is “what’s the difference between a Roth and Traditional IRA?” I wish I’d known a lot sooner, but it’s better to learn late than to never learn.
AND it’s much better to get started than to wait until we know everything. When it comes to investing, time is the KEY.
Let’s start with a few definitions.
IRA stands for individual retirement account. These accounts operate very similarly to 401(k)s but we can open them on our own, for ourselves.
A 401(k) is a retirement plan offered through our employers. We cannot open them if our employer doesn’t offer them as a benefit. 403(b)s are very similar but are retirement plans offered by tax-exempt organizations like schools and nonprofits.
We can contribute to two types of IRAs - Traditional and Roth. Our 401(k)s and 403(b)s can be available as Roth and Traditional accounts, but it will depend on what our employers offer. More and more I’m seeing both options available.
What do Roth and Traditional actually mean?
The main difference between Roth and Traditional accounts is the tax treatment. Roth IRAs are funded with post-tax dollars, meaning you don’t get a tax break when you contribute the money. You also don’t pay taxes when you take money out in retirement.
Traditional IRAs are the opposite. Traditional IRAs are funded with pre-tax dollars (so you don’t pay taxes on your contributions) but you do pay taxes when you take the money out in retirement.
“Fun” fact: there is no difference between the amount of money you’ll have in a Traditional vs. Roth account if your tax rate is the same when you contribute the money as it is when you take the money out.
The important differences: taxes
This makes taxes the key difference between a Roth and Traditional IRA. If you believe you’ll be paying higher taxes when you retire, it makes the most sense to pay taxes now and contribute to a Roth. Roth accounts typically make more sense for people who are earlier in their careers and are in lower tax brackets now than they will be when they will retire.
Contributing to a Roth also allows you to mitigate some tax-risk. We can’t really know what taxes will look like in retirement - they might be lower or they might be higher. By paying them now, we remove that variable from this part of our retirement plan.
The important differences: income limits (how much you can earn)
There are income limits that might make you ineligible for a Roth IRA. In order to be able to contribute to a Roth, your modified adjusted gross income (MAGI) has to be under $137,000 if you’re single and $203,000 if you’re married and filing jointly.
But wait… there’s a back door.
If you want to contribute to a Roth IRA and are above the income limit, you can contribute to a Traditional IRA and then convert it to a Roth account in order to get around the income limits. This is a legal strategy!
A Traditional IRA does not have income limits so anyone can contribute. There are, however, limits to when you stop getting a tax deduction for contributing. This will depend on how much you contribute to another plan, like a 401(k) or 403(b) at work, as well as your income.
The important differences: withdrawing money
For both accounts, you can start taking money out at 59 ½ years old. For Roth accounts, the money has to have been in the account for at least five years. With a Traditional IRA, you are required to take money out starting at 70 ½ years of age, while you are never required to take money out with a Roth IRA. This requirement is called a required minimum distribution (RMD).
With the Roth IRA, you can continue to contribute money at any age. With a Traditional IRA, you can’t contribute past 70 ½ years old. This often makes the Roth a better option for handing down money as you can continue to contribute to it after 70 ½ and aren’t required to take minimum distributions.
The important differences: pre-retirement withdrawals (taking out money before 59 ½ )
So what happens if you take money out of these accounts before you’re 59 ½? With the Roth account, you can take out the amount you contributed without a penalty, but you’ll pay a 10% penalty on any investment growth. Let’s say you contribute $5,000 every year for five years for a total of $25,000. You can take out that $25,000 penalty-free because that’s what you contributed. Let’s also say the $25,000 you contributed has grown to $40,000 because it’s been invested. If you withdraw anything above the $25,000, you will pay the 10% penalty.
With a Traditional IRA, you’ll pay a 10% penalty on all withdrawals.
What do the Roth and Traditional accounts have in common?
How much you can contribute. In 2021 you can contribute up to $6,000 if you are under 50 years old and $7,000 if you are over 50 years old.
The deadline to contribute. You can contribute up until the tax deadline. The deadline to contribute to your IRA for 2021 will be April 15, 2020 (as of now!).
Help for first-time homebuyers. With both accounts, you can take out up to $10,000 penalty-free to put towards first-time homebuyer expenses.
How to choose
Now that you understand the most important differences between a Roth and Traditional IRA, you can decide which makes the most sense for you. Generally, Roth accounts make the most sense for people who believe they will be in a higher tax bracket when they retire. Traditional accounts make the most sense for people who will be in a lower tax bracket when they retire.
Roth accounts provide no current year tax benefits. Traditional accounts can provide immediate tax write-offs depending on your income as well as how much you’ve contributed to an employer-sponsored plan.
Roth accounts offer tax-free withdrawals in the future and the Traditional IRA offers tax benefits in the current year.