Roth IRA vs. Traditional? A Comparison

October 8, 2021

A Roth IRA vs. traditional IRA is a choice based on taxes and income. Here’s a look at the differences and how you can choose the right account for your needs.

Out of all the investment accounts on the block, the 401(k) is the fan favorite of the pack. But it’s not the only option on the market—in fact, IRAs are a fantastic investment for retirement, even if you already have a 401(k).

This is for two reasons: 1) like a 401(k), IRA contributions grow free of Uncle Sam’s clutches, and 2) unlike a 401(k), you have far greater control over what you put in the account and how you grow it.

The trick is finding the right type of IRA for you. For most investors, that’s the choice between a Roth IRA and a traditional IRA. Here’s a breakdown of Roth IRA vs. traditional IRA and how to choose the right one for you.

What is a Traditional IRA?

Among IRAs, the traditional IRA is the elder statesman.

Basically, a traditional IRA is a type of tax-advantaged individual retirement account that allows you to stow money for retirement without the IRS knocking for its cut. You can even get a tax deduction for your contributions.

How It Works

Let’s say you open a traditional IRA through a bank, a brokerage firm, or a robo-advisor (that matters more than you think—banks generally offer savings accounts and certificates of deposit, while robo-advisors and brokerages allow you to invest in stocks and bonds).

As of 2021, the total contributions you make to your IRA for the year can’t be more than $6,000 ($7,000 if you’re over 50, or if it’s less, it can be equal to your taxable compensation for the year). This applies even if you’ve also made contributions to a 401(k) or other employer-sponsored plan. You can also add to the account by rolling money over from a different retirement account.

These contributions are generally made with after-tax money and can grow in your account tax-deferred. In other words, you don’t pay taxes on gains until you withdraw them after age 59.5. If you withdraw prior to that age, that withdrawal is taxed as income and subject to a 10% penalty.

What is a Roth IRA?

A Roth IRA (named for the senator who championed them) is another form of tax-advantaged individual retirement account. Like a traditional IRA, you can put almost any investment in a Roth IRA. Think of it as a tax-advantaged wrapper—the tax advantages of the wrapper have no effect on the investments contained inside beyond the fact of when you pay taxes on gains.

How It Works

Like a traditional IRA, a Roth IRA can be opened at a bank, a brokerage firm, or a robo-advisor, with similar investment options at each one. Roth IRAs have the same annual contribution limits as traditional IRAs.

Unlike a traditional IRA, a Roth IRA requires you to pay taxes on your contributions up-front, which means the contributions are not tax-deductible. Here’s the silver lining: your withdrawals in retirement are tax-free. In fact, you can withdraw from your Roth at any time without paying taxes on the withdrawals (you will have to pay a penalty if you withdraw before the age of 59.5, though).

Plus, you can choose when and how much you contribute to your Roth. You could contribute $6,000 in monthly installments throughout the year, or you could drop $6,000 into the account on the first day of the year and forget about the account for twelve months.

Roth IRA vs. Traditional IRA

In simple terms, Roth and traditional IRAs are both tax-advantaged accounts with the flexibility to save for retirement on your terms. They’re both pretty forgiving and open to most investors, and you can manage the accounts as you see fit.

Here’s how they’re different and how you can choose the right one for you.

Key Differences

In truth, Roth IRAs and traditional IRAs have more features in common than differences. Ultimately, they’re both IRAs, and they follow most of the same rules.

There are two key differences between them:

  • When taxes happen
  • Income limits

In a traditional IRA, you don’t pay taxes until you make withdrawals in retirement (or, if you withdraw early, that withdrawal becomes taxable income). In a Roth IRA, you pay taxes up-front but don’t pay taxes on gains when you make withdrawals (even if you make early withdrawals).

While both accounts are open to most investors, Roth IRAs come with an upper income limit. In order to qualify for a Roth IRA, you must earn less than $125,000 per year (if you’re single) or less than $198,000 per year (if you’re married and filing jointly).

How to Choose

Because of these key differences between traditional and Roth IRAs, choosing between them is mostly a question of taxes and income eligibility.

If you earn more than $125,000 per year as a single filer or more than $198,000 per year as a married joint filer, you’re not eligible for a Roth IRA. That said, if you’re eligible for a while and lose eligibility due to higher income, you can rollover your Roth into a traditional IRA.

Then there’s the tax issue. If you expect to have a higher income in retirement (which is actually possible between Social Security, fully-grown kids, and some side hustles) a Roth IRA is a better fit. If you expect to have less income in retirement, and thus a lower tax bracket, a traditional IRA is the better choice.

As a rule, unless you’re an extremely disciplined saver, a Roth IRA will deliver more after-tax money than a traditional IRA. Since the tax break happens in retirement, you’re highly incentivized to avoid withdrawal until retirement. The only way to break even is if you threw all your tax savings from a traditional IRA back into the account, which most people are not disciplined enough to do.

Learn More About Maximizing Your Retirement Savings

The choice between a Roth IRA vs. traditional IRA is a question of your personal situation. Once you understand your finances and your habits as a saver, you can make the right investments for your golden years.

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