Which is Better: Roth or Traditional Retirement Accounts?
Retirement accounts can be either traditional or Roth. The most common type of Roth style account is the Roth IRA. But you can also have a Roth 401(k) account. On the other hand, most retirement accounts are “traditional” style accounts. The SEP-IRA is an example of traditional retirement accounts.
All this talk about Roth versus traditional probably has you wondering what the difference between the two is - and (arguably more importantly) what’s the right type of retirement account for you! That's what I’m going to help explain today!
The truth is, the difference between a Roth and Traditional account isn’t actually that big of a deal. What’s most important is that you are actually contributing to some type of retirement account. Whether that’s a Traditional or Roth is really just an optimization.
But that said, you do have to pick one type to get started with, so let’s discuss some of the basics.
The key (tax) difference between Roth and Traditional Retirement Accounts
The difference between a Roth and Traditional all boils down to when you pay income tax. Remember that retirement accounts are special vehicles through which to invest because they offer tax advantages. The government wants to encourage you to save for retirement and they do that by offering tax perks. But the specific flavor of the tax perk differs between Roth and traditional retirement accounts:
- In a Traditional account you receive an income tax deduction for the amount of the traditional retirement contribution you make. In other words, you avoid paying income taxes on those earnings TODAY. Instead, you pay income tax when you take distributions out of the Traditional IRA during retirement. You avoid taxes today (or this year) and instead pay income taxes in the future.
- The Roth IRA is taxed in the exact opposite way. With a Roth, you pay taxes today - and then do NOT have to pay taxes in retirement. When you contribute to a Roth, you get no income tax deduction. That means you pay income tax today. But then you never pay income tax again. So when you take a distribution from a Roth IRA in retirement, that distribution is free and clear of any income tax.
Is a Roth better than a Traditional Retirement Account?
The Roth sounds like a good deal - and it is. But it isn’t necessarily a better tax deal than the Traditional IRA. It all boils down to when you believe your income tax rate will be lower. You want to pay income tax when your income tax rate is lower.
- If you believe your marginal tax rate today is LOWER than it will be in retirement, you’ll pay less in taxes by using a Roth IRA.
- If you believe your marginal tax rate today is HIGHER than it will be in retirement, you’ll pay less in taxes by using a Traditional IRA.
Can you predict future tax rates? I sure can’t! Which is why I suggest you don’t get too hung up on which is better. In general, I suggest folks keep a mix of both Roth and traditional retirement plan balances. It’s another form of diversification - which is always an important element of any solid investing plan.
Roth versus traditional retirement accounts is TAX diversification. Having retirement funds in both traditional and Roth accounts gives you flexibility around how and when you pay taxes once you reach retirement - and that can help you pay less in taxes over the course of your lifetime.
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Helpful Roth vs. Traditional Rules of Thumb
I usually suggest a Roth early in your career when your earnings are lower. You might also want to contribute to a Roth if you’re currently living in a low (or no) income tax state and think you might retire in a state with a higher income tax.
If you suspect your income is much higher today than it will be in retirement, then there’s a good chance that contributing to a traditional retirement plan will give you a slight tax benefit relative to a Roth contribution.
But remember - you don’t need to get this perfect. Contributing to your retirement savings is the important part. You can - and in many cases should - have investments in both Roth and traditional retirement accounts.
That's a Wrap 🎬
That's it for this today's post. I know we covered a lot and yet it is but one small part of navigating the entirety of your financial life.
If this all feels a bit much, give me a shout. I work one-on-one with therapists from all over the country helping them address issues just like the ones we talked about today! Learn the different ways you might work with me on my services page.
Turning Point is a registered investment advisor in the state of California. Please visit turningpointhq.com for important information and additional disclosures. This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes financial, legal or tax advice; a recommendation for purchase or sale of any security; or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Read the full Disclaimer here.