When it comes to saving for retirement, choosing the right type of account can make a huge difference.
Two of the most popular options are Roth and Traditional accounts. Each has its own set of advantages and considerations, and the best choice for you will depend on your individual financial situation and goals.
In this blog, I will break down the key differences between Roth and Traditional accounts to help you make an informed decision.
Understanding Roth and Traditional Accounts
Roth Accounts:
- Roth IRA (or backdoor Roth IRA): Contributions are made with post-tax dollars, meaning you don't get a tax deduction when you contribute. However, the money grows tax-free, and qualified withdrawals in retirement are also tax-free.
- Roth 401(k): Similar to a Roth IRA, contributions are made with after-tax dollars. The main difference is that Roth 401(k)s are offered through an employer, and contribution limits are higher.
Traditional Accounts:
- Traditional IRA: Contributions are made with pre-tax dollars, which can lower your taxable income for the year. The money grows tax-deferred, meaning you don't pay taxes on it until you withdraw it in retirement.
- Traditional 401(k): Also funded with pre-tax dollars and offered through an employer. Like a Traditional IRA, the funds grow tax-deferred, and you pay taxes upon withdrawal.
Key Differences
- Tax Treatment:
- Roth Accounts: Pay taxes now, enjoy tax-free growth and withdrawals.
- Traditional Accounts: Get a tax break now, pay income taxes later when you withdraw the money.
- Contribution Limits:
- Roth IRA: $7,000 per year (or $8,000 if you're 50 or older).
- Traditional IRA: $7,000 per year (or $8,000 if you're 50 or older).
- Roth 401(k) and Traditional 401(k): $23,000 per year (or $30,000 if you're 50 or older).
- Income Limits:
- Roth IRA: Contributions are phased out at higher income levels. For 2024, single filers can contribute fully if their Modified Adjusted Gross Income (MAGI) is less than $161,000. For married couples filing jointly, the limit is $240,000. If your income is above this, you cannot contribute at all.
- Traditional IRA: No income limits for contributions, but there are limits for tax-deductibility if you or your spouse have a retirement plan at work. If you make above $77,000 (single) or $143,000 (married) then you cannot deduct your contributions (unless you do not have a company sponsored retirement plan).
- Required Minimum Distributions (RMDs):
- Roth Accounts: No RMDs during the account holder's lifetime, making them ideal for estate planning.
- Traditional Accounts: RMDs must start at age 73, which can increase your taxable income in retirement. This is a huge thing! If you have a ton of pre-tax dollars and do not need them, it does not matter. You have to take the money out which can lead to lots of extra taxes.
Pros and Cons
Roth Accounts:
- Pros:
- Tax-free growth and withdrawals.
- No RMDs, providing more flexibility in retirement.
- Beneficial if you expect to be in a higher tax bracket in retirement.
- Cons:
- No immediate tax break.
- Income limits for contributions (Roth IRA).
Traditional Accounts:
- Pros:
- Immediate tax deduction, reducing your taxable income.
- No income limits for contributions.
- Beneficial if you expect to be in a lower tax bracket in retirement.
- Gives you options down the line for Roth conversions.
- Cons:
- Withdrawals are taxed as ordinary income.
- RMDs start at age 73 whether you need the funds or not.
Which One Should You Choose?
The decision between Roth and Traditional accounts largely depends on your current and expected future financial situation. Here are a few scenarios to consider:
- If you expect to be in a higher tax bracket in retirement: A Roth account might be more beneficial since you'll pay taxes now at a lower rate and enjoy tax-free withdrawals later.
- If you expect to be in a lower tax bracket in retirement: A Traditional account could be advantageous because you'll get a tax break now and pay taxes later at a lower rate.
- If you expect to retire early: A traditional account could be great because you can do Roth conversions in early retirement and lock in a lower tax rate.
- If you want flexibility and no RMDs: A Roth account offers more flexibility since there are no required distributions during your lifetime.
- If you need a tax break now: A Traditional account provides an immediate tax deduction, which can be helpful if you're looking to reduce your taxable income.
- If you are young a high income earner: A Roth account might be the right move. You will get a lot of years of tax free growth. Plus, you do not want all pre-tax dollars.
Conclusion
Both Roth and Traditional accounts offer valuable benefits for retirement savings. The best choice for you will depend on your individual financial situation, tax considerations, and retirement goals. And remember, what you do can change each year based on your situation.
By understanding the key differences and evaluating your own circumstances, you can make a more informed decision that aligns with your long-term financial strategy.
If you have any questions or need personalized advice, feel free to reach out. We help all our clients evaluate this.
