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.
🤓 And just in case you want to know more than Andy Dwyer, Roth is Delaware Senator William Victor Roth, who laid down the basis for Roth accounts as part of the Taxpayer Relief Act of 1997.
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.
Contribution Rules
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.
Distribution Rules
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.
👉 Example:
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 | $50,000 | $50,000 |
| Contributions | $6,000 | $6,000 |
| Taxable Income | $50,000 | $44,000 |
| Federal Taxes | $8,140 | $7,420 |
| Income After Taxes and Contributions | $35,860 | $36,580 |
| Expenses | $30,000 | $30,000 |
| 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.
👉 Want to see what compound interest can do for you? Check out our calculator to play around with the numbers: Compound Interest Calculator
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.
Why It Makes Sense to Invest in Both
People have a bad habit of seeing their options as black and white. We vote Republican or Democrat, drink coffee or tea, and love cats or dogs. But that tends to backfire more often than not. It’s definitely something to avoid when choosing between Roth and traditional retirement accounts.
In this case, permanently picking one over the other is like deciding that turning left is better than turning right. You’ll get to your destination much faster if you take advantage of both options.
Let’s take a look at why it makes more sense not to limit yourself.
Contributing During Working Years
The primary reason to contribute to either Roth or traditional retirement accounts is to take the tax deduction when your marginal tax rates are highest. Your working career will probably last for decades, so you’ll have to constantly reassess how your rates compare to what you expect to pay in retirement.
People usually enter the workforce in their early twenties and retire somewhere around their sixties. Most people earn more toward the end of their careers. Because America’s income tax system is progressive, raising your earnings will also raise your marginal tax rates.
👉 Here’s an example to show you how this impacts the decision to contribute to Roth or traditional retirement accounts:
If you started working in 2020 making $40,000 a year, your marginal tax rate would be 12%. Contributing to a Roth account would make the most sense at this point. It’s unlikely that your tax rates would be any lower in retirement. You’d already be in the second-lowest tax bracket, which is only 2% higher than the one below it.
After ten years of 5% annual raises, your salary would be roughly $65,000. Assuming that tax brackets didn’t change, your marginal tax rate would then be 22%. It would make more sense to contribute to a traditional account at this point. You’d be unlikely to reach the same income or tax bracket in retirement.
Taking Distributions in Retirement
So far, it seems like the best choice would be to contribute to Roth accounts until your income exceeds what you plan to need in retirement. At that point, you could switch to traditional retirement accounts to maximize your deductions.
Unfortunately, it’s not that simple. In reality, it’s difficult to know for sure what you’ll need to support yourself in retirement. You might be able to live happily off $30,000 a year when you’re 25, but you’ll probably need more when you’re 65. Just how much more you’ll need is impossible to predict. Lifestyle inflation and potential health complications will both have an unknowable impact on your future budget.
👉 Looking for ways to live a cheaper lifestyle in retirement? Check out some of our best ideas: 11 Easy Money-Saving Tips for Seniors
Even if you knew exactly how much income you’d need to afford your future lifestyle, it’s unlikely that overall tax brackets would remain the same. Without knowing how they’ll change, you have no idea whether you’d be better off with the deduction while working or in retirement.
And if anything, it’s likely that tax rates will trend up, given the federal government’s overspending problem. Falling into a lower tax bracket personally while overall rates go up would produce an unknowable net effect. Most current proposals for raising taxes focus on the higher brackets and would have little impact on less wealthy workers, but that trend could also change.
The bottom line is that it’s impossible to know with absolute certainty when you’ll benefit most from Roth or traditional retirement accounts. You can make educated guesses, but contributing to both is the best way to hedge your bets.
Having Both Lets You Leverage Asset Location
Having both types of retirement accounts also helps you diversify your investment holdings. Diversification is one of the fundamental principles of smart investing: it’s always safer to put your eggs in multiple baskets, rather than just one. People usually take that to mean that you should invest in multiple asset classes, but it also means you should split your investments between multiple types of accounts.
Diversifying your account types intelligently is also known as optimizing your “asset location.” With both Roth and traditional retirement accounts, you can put asset classes in accounts that get the most efficient tax treatments for their attributes.
👉 For example:
It’s usually better to put stocks in Roth accounts. Stocks are volatile, but they provide much larger returns than bonds, on average. Growth is much more tax-efficient in a Roth account than a traditional account since you won’t have to pay taxes on it.
Conversely, it’s more tax-efficient to put wealth preservation assets (like bonds) in traditional accounts.
Having multiple asset locations also allows you to smooth out your income levels.
👉 For example:
Imagine that you retired in 2020 and need $20,000 to support yourself. You could stay in the 10% tax bracket with the standard deduction. Whenever you have unexpected expenses, you could draw on your Roth accounts to keep your taxable income from rising into higher tax brackets.
Consider a Traditional 401(k) and a Roth IRA
One of the most common ways people split their funds between retirement accounts is by contributing to a traditional 401(k) and a Roth IRA. Roth IRAs allow you to take out your contributions without any penalties and avoid Required Minimum Distributions (RMDs), but Roth 401(k)s don’t. An RMD is a mandatory annual disbursement from your account starting at the age of 70 1/2.
The Roth IRA’s exemption from RMDs can be a real advantage. Lifespans are increasing, and accounts with mandatory disbursements could run out while you’re still alive. Your Roth IRA can remain in reserve (and still earning) for late in your retirement.
💡 If you don’t use it you can pass your IRA (and its tax-free privilege) to your heirs.
While this split works for many people, it’s not going to be viable for everyone. Some people’s employers don’t offer 401(k) plans, and self-employed people can’t access 401(k)s unless they start their own.
In any case, it’s best to consult an expert before committing to Roth or traditional retirement accounts. Retirement planning is extremely nuanced, and it’s always safest to consult with a financial advisor or Certified Public Accountant to figure it all out.
📘 To learn more about the various types of retirement accounts, take a look at our breakdown of the best options: An Introduction to Tax-Advantaged Retirement Accounts
