You’ve probably heard of “Roth” retirement accounts before, but have you ever taken the time to figure out exactly what the term means? If not, we don’t blame you. Most discussions about taxes and retirement are full of unnecessary jargon, and it can feel overwhelming to sort through it all on your own. So if you’re like Andy Dwyer in Parks & Recreation, unsure of who Roth is and too afraid to ask at this point, don’t worry. Here’s everything you need to make an informed decision between Roth and traditional retirement accounts.
Tax Timing: The Fundamental Difference
The fundamental difference between Roth and traditional retirement accounts is in their tax timing. They trigger taxable income at opposite ends of the investing cycle. You either pay taxes when you make your contributions (Roth) or when you take distributions (traditional).
👉 For example:
Imagine that John makes $70,000 a year and wants to put $5,000 a year into a retirement account.
If he puts the $5,000 into a traditional account, he could take a $5,000 deduction and shelter that amount from taxes for the year. When he retires and takes the money out of his traditional account, he would then have to pay ordinary income tax on the funds.
If he put it into a Roth account, he would get no tax deduction for the year. His income would still be $70,000, and he’d pay taxes on all of it. But when he takes the money out of the Roth account in retirement to pay his bills, it would be completely tax-free.
Keep in mind that while the IRS taxes money differently as it comes in and out of Roth and traditional accounts, they treat it the same (tax-free) while it grows within both types. Your investment earnings will not be taxed in either case.
Roth vs. Traditional IRAs
401(k)s and Individual Retirement Accounts (IRAs) are two of the most popular types of retirement plans. They’re both defined-benefit contribution plans, and they’re the ones that usually offer Roth variations.
Other than the difference in tax timing, Roth and traditional 401(k)s follow the same rules. They have the same contribution limits and distribution requirements, and there are no income limitations for either version.
📘 Looking for alternatives to the common types of retirement accounts? Take a look at the best options here: 401(k) Alternatives.
There are a few extra differences between Roth and traditional IRAs. Those details have a significant impact on their place in your retirement plan.
Here are the ways that Roth and traditional IRAs differ other than their taxation.
To contribute to a retirement account, you’ll need employment or self-employment income. All retirement accounts limit your contributions to what you make during the tax year. That means you might not always earn enough to contribute the full legal limit to a retirement account.
In some cases, you can also earn too much. Roth IRAs are one of them. If your modified adjusted gross income (MAGI) gets too high, your Roth IRA contribution limit will decrease. After another $10,000 to $15,000, it’ll disappear completely.
Here are the phase-out ranges for each filing status in 2021:
- Single or Head of Household: $125,000 to $140,000
- Married Filing Jointly or Qualified Widow(er): $198,000 to $208,000
If you’re Married Filing Separately, the phase-out range depends on whether you lived with your spouse during the tax year. Those who lived apart can use the Single filer range. But for those who lived with their spouse at all, the phase-out range starts with the first dollar and ends at $10,000.
Traditional IRAs don’t have any income limitations for contributions, but you might not qualify for the entire tax deduction if you (or your spouse) try to deduct 401(k) contributions and IRA contributions at the same time.
Here are the phase-out ranges for deducting contributions when you or your spouse are covered by a 401(k) or another employer-sponsored plan:
- Single or Head of Household: $66,000 to $76,000
- Married Filing Jointly or Qualifying Widower: $105,000 to $125,000
Note that these are relatively low income limits. It’s usually best not to try to contribute to a traditional IRA if you’re already contributing to a traditional 401(k).
If you’re not covered by a 401(k) plan at work, your traditional IRA contributions will always be deductible.
Roth IRA distribution rules are more favorable for the taxpayer than traditional IRA rules. You’ve already paid tax on the money, so the IRS is much less concerned with what you do with it. In addition to being tax-free, they have the following advantages:
- No Required Minimum Distributions (RMDs): Traditional IRAs require that their owners start taking distributions from their accounts once they turn 72. Your RMD amount is a function of your account balance and remaining life expectancy. Failure to take RMDs will cost you 50% of the required distribution in penalties.
- Accessibility of Contributions: Because contributions to Roth IRAs are after-tax, you can distribute them from the account at any time without penalty or taxes. With other retirement accounts, there’s no way to access any of the assets before age 59 ½ without facing penalties, unless you meet one of the few exceptions.
These Roth IRA advantages aren’t always going to come into play. You’ll probably want to use your retirement funds, so the IRS might not need to force you to take distributions. Taking your contributions out early will sabotage the growth of your retirement accounts, so it’s rarely a good idea.
Still, both benefits offer extra flexibility. Some people might want to have a fund with no RMD tucked away (and still earning) for late in their retirement, or even to pass on to their children. It might give others peace of mind to know that they can take cash out of their Roth IRA if they ever fall on hard times.
Roth vs. Traditional: The Practical Impact
Conceptually, the differences between Roth and traditional accounts are easy enough to understand. It’s still hard to grasp the practical implications without seeing the math. Let’s take a look at an example to see how choosing one over the other would play out.
Imagine that our old friend John wants to calculate how much money he would have in the future if he put $6,000 toward one type of IRA for 30 years, then invested his remaining savings into a taxable brokerage account.
John makes $50,000 a year, lives in a state with no income tax, and needs $30,000 a year to support himself. Here’s what the math would look like.
|Roth Account||Traditional Account|
|Income After Taxes and Contributions||$35,860||$36,580|
|Cash Left to Invest in Brokerage Account||$5,860||$6,580
|IRA Balance in 30 Years||$604,925||$604,925|
|Taxes on Distribution||0||$60,492|
|After-Tax Value of IRAs||$604,925||$544,432|
|Brokerage Account Balances||$590,810||$663,401|
|Total Retirement Funds||$1,195,734||$1,207,833|
1. Future IRA account balances represent compound interest of 8% annually.
2. Future brokerage account balances represent compound interest of 7% annually to take into account tax drag.
John’s IRA balances would be identical after 30 years, but distributions from his traditional account would be taxable. If he were to pay an average tax rate of 10% on them, his traditional IRA would be worth $60,492 less than the Roth IRA.
However, he was able to invest more over the years due to the tax savings from his traditional IRA. That means his brokerage account would be worth $72,590 more than it would have had he gone with the Roth IRA.
Roth vs. Traditional: Which is Better?
In John’s example, the final retirement fund totals were virtually the same. But if he had done things just a little differently, the results would have strongly favored one or the other.
👉 For example:
- If John had spent his annual tax savings from his traditional IRA instead of saving them in a brokerage account, the Roth would have been a much better choice.
- If John had made less money and could not afford to save $6,000 in an IRA without the tax deduction from the traditional account, the traditional would have been the much better choice.
The example also assumed that tax rates stayed consistent across his entire working career and eventual retirement. If they didn’t, choosing one or the other account type would be noticeably superior.
Generally, you should try to take the tax deduction when your tax rates are highest. If that’s while you’re working, use the traditional account. If that’s in retirement, use the Roth account.
Two factors affect your tax rate:
- Where your income puts you in the tax brackets
- Changes in the tax brackets themselves
Unfortunately, it’s impossible to predict when your effective tax rates are going to be higher or lower. Most people make more while they work and less in retirement, but many experts believe tax brackets will go up in the future. Many people also have fewer deductions in retirement.
Fortunately, choosing between Roth and traditional requirement accounts isn’t a binary decision. You can, and probably should, take advantage of both types.
Do you have any questions about Roth vs. traditional retirement accounts? Let us know in the comments!
📘 Learn More: Roth or Traditional Retirement Accounts: Why Not Both?