This article was written by our guest Jennifer from Fab Fem Finance. All thoughts and advice expressed are solely those of the author. Enjoy!
Traditional IRA or Roth? What are they? Which is right for me?
The decision can be tricky. It’s mostly based on your tax rate today and what you expect it to be in the future. But it’s something you need to think about carefully. Are you planning to retire early or achieve financial freedom or are you on the “usual” timetable?
Both Traditional and Roth accounts are tax-deferred, meaning you don’t pay any tax on the money while it’s in the account.
You might pay regular taxes and then contribute the money into a Roth IRA. Or, you might deduct the amount you contribute from your taxes, which is a Traditional IRA.
Either way, it grows tax-deferred inside the account before you begin taking money out.
While this article is focused on IRAs, the content can work for employer plans like a 401(K) as well. There are some differences in the rules between a Roth 401(K) and a Roth IRA, but the principles remain the same.
Contribution limits for IRAs are much lower than they are for employer plans. If you’re eligible, you should maximize your contributions to the company plan before you start investing in IRAs.
This is true even if your employer offers a match or the plan contains a Roth component. If you can put more away to grow tax-deferred with the company plan, you should do that first.
The traditional IRA was introduced first. They are pre-tax, meaning it’s a deduction on your tax return. Deductibility is phased out once you’re above certain income levels, if you’re also covered by an employer retirement plan.
If no retirement plan exists at your employer, then it’s fully deductible. If you’re currently in a high tax bracket, this deduction can be valuable.
Since you contributed without paying taxes, you’ll have to pay them when you make withdrawals. When you take the money out, you’ll pay ordinary income tax on the entire amount at that time.
This “flavor” of retirement plan is suited for someone who is currently earning a significant income in a high tax bracket and who expects their taxes to be lower in the future when they’re old enough to take the money out (and presumably retired).
If you’re not making very much right now (so you don’t pay much in taxes), the tax deduction isn’t as valuable. You’re probably better off with a Roth.
Rules for Traditional Plans
Crucially, you need to be 59 ½ to withdraw funds or you’ll pay a 10% penalty on the withdrawal. There are some exceptions to this. However, as a matter of principle, your retirement funds should be held for retirement.
When you turn 70 ½, you must take required minimum distributions (RMDs). The amount you’re required to withdraw starts off around 4% of the IRA money you have and rises from there as you grow older.
Once you’ve reached that age, you can send withdrawals directly to a qualified charity. This is pretty much the only way you can avoid paying the taxes on the money you’re taking out.
Always remember these rules are written by Congress. What Congress giveth, Congress can taketh away. There’s always talk about amending the Roth rules to be less generous. In fact, the recent tax act (TCJA) removed a Roth conversion benefit.
So, you may want to take advantage of these benefits while you can.
Roth IRAs are after-tax dollars. That means there’s no tax deduction when you make the contribution. The advantage to this is when you reach age 59 ½ and have had the account for at least five years, all the funds you take out are tax and penalty free. The same exceptions to the early withdrawal penalty apply.
Above a certain income, you can’t contribute to a Roth anymore (it’s a pretty high ceiling.)
You can contribute to a Traditional IRA instead, if you’re phased out. You won’t get the tax deduction, but you will still get the tax deferral before you start taking money out. (There are rules, as you would expect, as to how much of the after-tax money you can withdraw at any one time from your Traditional IRA.)
Plus, there’s no 70 ½ RMD for a Roth. You paid the taxes already.
You can always, no matter what your age or how long you’ve had the account, remove your contributions without a tax or penalty. But the earnings can be taxed and/or penalized.
If you withdraw earnings and you haven’t had the account for five years, you’ll pay taxes on the earnings. Even if you’re over 59 ½. If you’re under 59 ½, you’re penalized 10% of the earnings. And if you’re under 59 ½ and you haven’t had the account five years, taxes and penalties apply.
The five-year clock starts when you first contribute the money. You can add contributions without “resetting” the clock, except for Roth conversions, as discussed later.
Who should do a Roth instead of a Traditional? The Roth is great for someone who’s not making much income now. The tax deduction isn’t as valuable to someone in a lower tax bracket. And especially when you’re young, you have a lot of time to let that growth compound tax-free, not just tax-deferred.
A Roth conversion can be a neat little trick when done properly. Due to the TCJA, you can’t undo them, so make sure it makes sense before you go ahead with it! You withdraw money from your Traditional IRA and put it, or “convert” it, into a Roth IRA.
The great advantage to this is that there is no income ceiling (as there is with Roth contributions), and the usual withdrawal penalty under age 59 ½ doesn’t apply. So technically, you could be making millions of dollars at age 30 and still convert your Traditional IRA into a Roth to grow tax free.
Notice I said technically. Because you’re taking money out of a Traditional account, you owe taxes on the entire amount of the conversion. So, if you’re making millions, you‘re in a high tax bracket…and that conversion could cost you a lot of money in taxes.
The amount of the conversion is taxable because it’s considered income. It’s definitely possible to convert too much, so that the amount of the conversion plus your normal income puts you in a higher tax bracket.
If you’re in a low tax bracket, you don’t want to convert so much that you pay more in taxes as a result of being pushed up an income bracket.
Roth conversions are great to do in low earnings years. For example, let’s say you got laid off and it took you a while to get another job. That tax year with the lower earnings might be a good year to convert a portion of your Traditional plan.
Or, if you are in a higher tax bracket but you’re at the lower end of it, you could consider a Roth conversion to “fill up” that space before you get to the next tax bracket.
What am I talking about? (I’m going to completely make up numbers here – these are not real tax brackets.) Suppose your income is $50,000 and you’re in the 15% marginal tax bracket. Incomes between, say, $25,001 and $75,000 are taxed at 15%. So the next marginal tax bracket is 20% and applies to incomes between $75,001 and $100,000.
At $50,000, you still have $25,000 of income you can claim before you’re in the higher bracket. So you might consider converting up to $25,000 of your Traditional IRA, which you’ll still only pay 15% tax on.
Just be careful that you don’t go over, because you can’t undo a conversion or part of a conversion anymore. I strongly recommend checking with an accountant before you start converting!
Also, bear in mind that conversions have their own 5-year clock. Contributions to a Roth start the clock as of the first contribution, but you have to wait five years after you convert for that sum to be available to you. If you convert some in 2019 and some in 2020, then what you converted in 2019 is available 2024. The amount in 2020 is available 2025.
Comparing Traditional v. Roth
There’s a certain segment of American society that has a lot of complaints about taxes. Tax professionals may urge their young clients who aren’t making any money to contribute to a Traditional, just to get the tax deduction.
They’re not looking at the client’s financial picture and how it may change over time. They’re looking at what looks good this year.
If you’re not making a lot of money and that is likely to change, you need to seriously consider the Roth.
One thing a lot of people don’t realize is you can have both of these things at the same time. I do! I started a Roth when I was in a low tax bracket, and then I opened up a Traditional later. When I left the companies where I had an employer plan, I rolled those into the Traditional. (None of the companies offered a Roth component.)
I don’t recommend contributing to both. The contribution limit to an IRA covers both types during the same year. But, someone starting off with a junior position and a junior salary might choose to contribute to a Roth at the beginning, like I did.
Later, when they’ve moved up to more responsibility and a higher income, the tax deduction might become valuable. They can stop contributing to the Roth, leaving it where it is. Then they open a Traditional so they can contribute to that and begin taking tax deductions. The money in the Roth, assuming they’ve invested it appropriately, will continue to compound.
Who benefits most from a Roth
- Just beginning a career or otherwise not making much money, and
- Expects to earn more in the future, and
- Plans traditional retirement around age 65-70
Who benefits most from a Traditional
- Currently in the high earnings years, and
- Expects income when retired will be lower, and
- Plans traditional retirement around age 65-70
What if I’m on a FIRE/Financial Freedom Plan?
You should leave tax-deferred accounts last for withdrawals, whether Roth or Traditional, because of the power of tax-deferred compounding. You’ll want to have enough in a taxable account to let the accounts compound as long as possible. This decision may not be as clear-cut as it is for those aiming at “traditional” retirement.
Since you can always take out your contributions to a Roth at any time, this might seem a better bet than having a Traditional account. You won’t be penalized if you’re 40 and withdrawing from the Roth. As long as you’re not taking out earnings.
The entire amount of a conversion is considered a contribution, because you’ve paid taxes on it. So you could, if you’re currently in a higher tax bracket, contribute to a Traditional and take the deduction. Then, in a low earnings year, or when you stop working so your income decreases, you convert an amount that doesn’t push you into the next tax bracket.
However, the conversion has to sit for five years before you can withdraw it. You’ll need other income to cover this period of time first.
It’s probably easier to contribute to a Roth first and get the 5-year clock ticking, than to use the Roth conversion route. But if you’re currently at a high-earnings job and you plan to drastically decrease your earnings, going the Traditional route and converting later might work better.
So, which one should you choose? It depends! (People hate that answer.)
But as you can see, the decision varies according to current and future expected income, as well as expected retirement age. It’s often helpful to have both Traditional and Roth accounts to diversify your tax liabilities.
The important thing is to be saving for retirement. Don’t take money out because the market did something scary or you didn’t budget your money accurately.
I would argue that’s the fundamental decision you need to be making. Picking Traditional v. Roth is just icing on the cake.
Jennifer “JJ” Jank is a writer and financial expert who provides information on investing to beginners at www.fabfemfinance.com.