Which is Best: A Roth or Traditional Retirement Account?
Money Girl details what to know when choosing between a Roth or traditional retirement account – no matter if you use an IRA, a retiremment plan at work, or both. Plus, get the Retirement Account Comparison Chart to see how all the accounts stack up.
Laura Adams, MBA
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Which is Best: A Roth or Traditional Retirement Account?
Last week, I wrote about common IRA mistakes that keep you from building wealth for retirement. One of the missteps is getting stuck on the choice between a traditional or Roth account.
As more employers add a Roth option their 401k, 403b, or 457 plans, you may also be faced with the traditional versus Roth dilemma for your workplace retirement plan. In fact, I recently received several questions on this topic from Money Girl Podcast listeners.
Choosing the right type of retirement account can be confusing—especially because the Roth rules for workplace plans are slightly different than the Roth rules for IRAs.
So in this episode, I’ll explain what you need to know about going with a Roth or traditional account, no matter if you invest for retirement using an IRA, a workplace account, or both.
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Should I Have a Roth or Traditional Retirement Account?
There are several key differences between Roth and traditional retirement accounts. Which one you choose affects important issues like taxes on your contributions and withdrawals, and options for tapping funds early, if needed.
For a quick review, IRA is short for Individual Retirement Arrangement. You own one as an individual, and choose your own investments. For 2015, you can contribute up to $5,500 (or $6,500 if you’re over age 50) to one or a combination of IRAs.
Retirement plans through work, such as a 401k or 403b, are completely different from IRAs. They’re managed by employers only, offer a set menu of investment options, and require contributions to be deducted out of your paycheck. For 2015, you can contribute up to $18,000 (or $24,000 if you’re over age 50) to most workplace retirement plans.
Free Resource: Retirement Account Comparison Chart (PDF download)
To know whether you’re better off owning investments in a traditional or Roth retirement account, start by answering these 3 questions:
Question #1: What’s My Current Income?
This is the first question to answerm because there are annual income limits to qualify for a Roth IRA. However, this isn’t the case for a Roth account at work, or any type of traditional retirement account.
So, if your income is above the annual allowable limit, you’ll be locked out of opening up or contributing to a Roth IRA. Here are the thresholds by tax filing status for your modified adjusted gross income:
- Married filing jointly: $193,000
- Qualifying widow(er): $193,000
- Single: $131,000
- Head of household: $131,000
- Married filing separately (not living together): $131,000
- Married filing separately (living together at any time during the year): $10,000
If you already own a Roth IRA, and your income goes up and exceeds the annual allowable limit, you can continue to own the account with no penalty – you just can’t add new funds to it.
On the other hand, as I mentioned, there is no income limit to qualify for a Roth account at work. So you can have one no matter if you’re in an entry-level job, or happen to be the highest paid employee in the company.
See also: 10 IRA Facts Everyone Should KnowIn order to pay as little tax as possible, consider whether your income tax rate could be lower now relative to when you retire.
Question #2: Is My Tax Rate Likely to Be Higher or Lower in Retirement?
With any kind of traditional retirement account, you get a break by delaying taxes until you take withdrawalsin retirement. Roth accounts work the exact opposite way. With a Roth, you pay tax upfront, and then have no tax on withdrawals in retirement.
In order to pay as little tax as possible, consider whether your income tax rate could be lower now, relative to when you retire. If you believe that you’ll be in the same or a higher tax bracket in retirement, choosing a Roth IRA or a Roth at work, if available, is best.
The idea is that paying tax on Roth contributions upfront at a lower rate saves you money. Here are some situations where your tax rate could be higher in retirement than it is today:
- You’re currently in an entry-level job and expect to be earning more in the future.
- You expect to receive an inheritancein the future.
- You have a hunch that income tax rates for all Americans will escalate over time.
But if you’re further along in your career and earn more now than you believe you will in retirement, you’re generally better off with a traditional IRA, or traditional plan at work. When you take withdrawals in retirement, you’ll end uppaying less tax if you have a lower tax rate than you do today.
Also, if you have a heavy tax burden from high earned or investmentincome, making contributions to a traditional retirement account is a smart way to cut it. You’ll get a tax deduction in the year you make traditional retirement contributions, which reduces your current tax bill.
Problem is, none of us really know what will happen in the future – especially if you’ve got a long way to go until retirement. So, if you’re not sure about your tax rates, another tip is to diversifyby having both traditional and Roth accounts. That way you’ll have taxable and non-taxable money to spend in retirement.
For instance, you could put half your contributions in a traditional 401k and half in a Roth 401k. Or you might have a traditional retirement plan at work and a Roth IRA on your own, if you’re eligible.
See also: Should You Contribute to Both a 401k and an IRA?
Question #3: Do I Want Flexibility to Tap the Account Before Retirement?
Tapping a retirement account before you reach the official retirement age of 59½ typically comes with having to pay tax, plus a 10% early withdrawal penalty.
While you might think it’s unfair to have your wrist slapped, financially speaking, to access your own money, the purpose is to make sure you have funds to spend in retirement – not before!
However, there are some exceptions. Roth accounts give you much more flexibility than traditional ones when it comes to taking early withdrawals. And a Roth IRA, in particular, gives you the most access to your money.
Here are the rules for taking withdrawals from different accounts before reaching age 59½:
Traditional workplace retirement plans: may allow “hardship” distributions to pay for medical, funeral, or education expenses only. However, you must pay income tax on this, plus, in most cases, an additional 10% penalty.
Roth workplace retirement plans: may also allow “hardship” distributions to pay for medical, funeral, or education expenses. But as long as you’ve owned a Roth account at work for 5 years, you can withdraw contributions (but not earnings) tax-free. That’s because you pay tax upfront on Roth contributions.
Traditional IRAs: allow you to withdraw funds at any time, but require you to pay income tax plus the 10% penalty, unless you use them to:
- Buy, build, or rebuild a property that will be your first home, for up to $10,000
- Pay medical expenses that exceed 10% of your adjusted gross income
- Pay health insurance premiumswhile you’re unemployed
- Pay higher education expenses
Roth IRAs: allow you to withdraw contributions (but not earnings) tax-free, as long as you’ve owned the account for 5 years. And if you haven’t owned a Roth IRA that long, the exceptions to the 10% early withdrawal penalty that I mentioned above for a traditional IRA also apply. You can use early withdrawals from a Roth IRA to pay for a first home, medical, education, and health insurance and avoid the penalty.
While I recommend leaving retirement accounts untouched until you retire, having a Roth IRA does give you the most flexibility to tap your funds ahead of retirement. So if you’ve got a long way to go and are worried that you might need to spend some of your retirement savings, a Roth IRA is a good option.
In addition to these 3 questions I’ve covered, there are other features of traditional and Roth retirement accounts that may be important for your situation. For instance, whether you, or a spouse, have a retirement account at work could reduce the tax deductibility of a traditional IRA, depending on your income. Or whether you want flexibility for taking distributions during your retirement.
For a summary of all this information, plus more pros and cons of different retirement accounts, click here to download the Retirement Account Comparison Chart.
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.