Trying to choose between a traditional individual retirement account (IRA) and a Roth IRA? They both offer tax-advantaged ways to save for retirement, so your decision may come down to a simple-seeming question: What flavor of tax advantage would you prefer? Does it make more sense to put off paying taxes on your savings until you retire, or should you just get it over with and pay today so you don't have to do so later?
To be clear, this oversimplifies things quite a bit—these accounts come with various eligibility rules and contribution limits that could affect your choice—but doing some basic tax planning should get you in the right head space for making a final call.
Read on to learn more about these popular savings vehicles.
What’s the difference between a traditional and Roth IRA?
A traditional IRA is an individual retirement account that allows you to make contributions on a pre-tax basis (if your income is below a certain level) and pay no taxes until you withdraw the money. Starting at age 72, you’ll have to start taking mandated annual required minimum distributions (RMDs) from your traditional IRA. Those withdrawals are taxed as ordinary income; however, if you withdraw the money before age 59½, you may also be subject to a 10% early-withdrawal penalty and state-tax penalties.
In contrast, Roth IRA contributions are made with after-tax dollars. You can withdraw contributions to a Roth account anytime, tax- and penalty-free, and can withdraw your earnings tax-free after age 59½ if you’ve had the account for at least five years, or you meet certain other conditions.1 If you make an early withdrawal of any earnings, you must pay taxes and penalties on them. There are no annual RMDs with Roth IRAs.
How much can I contribute?
The maximum amount you can contribute across all your IRAs (traditional or Roth) in 2021 is $6,000—or $7,000 if you’re age 50 or older. However, some rules affect IRA contributions and deductibility.
To start, if neither you nor your spouse is offered a retirement plan by an employer, there’s no income limit for contributing to a traditional IRA, and your contribution is fully deductible. However, if either of you participates in a workplace retirement plan, deductibility phases out depending on your filing status and income.
With Roth IRAs, you can only contribute if your income meets certain limits.2
If you qualify for both accounts, how do you choose which one to contribute to?
A general guideline is that if you think your tax bracket will be higher when you retire than it is today, you may want to consider a Roth IRA—especially if you’re younger and have yet to reach your peak earning years.
Conversely, if you think you’ll be in a lower tax bracket when you retire, a traditional IRA can be an attractive option; you get the tax benefits when you’re in a relatively high tax bracket and can make your withdrawals when you’re potentially in a lower bracket.
If you think your tax bracket will be the same when you retire, it’s almost a wash for income tax purposes.
What are the advantages of a Roth IRA?
A Roth IRA can offer flexibility to manage your taxes and spending in retirement because you can withdraw money without increasing your tax bill—which could come in handy if, for example, you have a large, one-time expense after you’ve retired.
Roth IRAs let you withdraw contributions anytime for any reason without tax or penalty—but just because you can doesn’t mean you should, particularly if you’re fairly young. Taking money out of your Roth IRA means you may miss out on the potential for compounding gains for retirement. And when you can put in only $6,000 for 2021 plus an additional $1,000 catch-up contribution if you’re age 50 or older, it might be difficult to make up the amount you withdraw.
Finally, we can’t know future tax rates with certainty. Contributing part of your retirement savings dollars to a Roth IRA after paying taxes can add tax diversification to your retirement savings in the event Congress increases tax rates in the future or when you retire.
Other things to keep in mind
If you change jobs, you have the option to convert a traditional 401(k) directly into a Roth IRA without having to roll it into a traditional IRA first. Just remember, you must pay federal income tax on the full amount at the time of the rollover. Also, you may have other options, including keeping your assets in your former employer’s plan, rolling over assets to your new employer’s plan, rolling over assets to a new traditional IRA, or taking a cash distribution (on which taxes and possible withdrawal penalties may apply).
An increasing number of employers offer Roth 401(k) options in addition to traditional 401(k)s. With a Roth 401(k), you can contribute a portion or all of your paycheck up to certain limits. You can also choose to have some of your paycheck go pre-tax into a traditional 401(k) and some post-tax into a Roth 401(k). Any employer match or contribution, however, must go into a traditional 401(k).
Unlike with a Roth IRA, contributions to a Roth 401(k) are not subject to earnings limits. This means that if you aren’t eligible to contribute to a Roth IRA because your income is too high, you may be able to contribute to a Roth 401(k). You can also contribute more to a Roth 401(k) (up to $19,500 with a $6,500 catch-up contribution) than you can a Roth IRA.
Distributions from a Roth 401(k) are subject to the same general tax rules as a Roth IRA, with the exception of an RMD requirement. You can avoid the RMD by rolling over a Roth 401(k) balance into a Roth IRA after you retire but before your RMD age. If you’re eligible, don’t forget the Roth 401(k) option if a Roth makes sense for you.
Roth IRA conversions
If you’re ineligible for a Roth IRA because of income limits, some investors choose to make contributions to a traditional IRA and then later convert those contributions to a Roth IRA.
High earners who aren’t eligible to make Roth IRA contributions could make nondeductible contributions to a traditional IRA and then convert to a Roth (sometimes called a “backdoor Roth conversion”). However, there are some caveats.
You can’t pick and choose which portion of traditional IRA money is converted. The IRS looks at all earnings from traditional IRAs as one when it comes to distributions, including funds from Roth conversions. Traditional IRA balances are aggregated so that the amount converted consists of a prorated portion of taxable and nontaxable money.
So, making nondeductible contributions to a traditional IRA with the goal of later converting to a Roth IRA would likely work best if you have little or no existing deductible IRA balance to muddy the waters. Still, any earnings leading up to conversion would be subject to income tax. We generally suggest that the tax be paid with other funds, not withdrawals from the IRA, to maximize the amount available to convert and contribute to the Roth account.
The bottom line
Both traditional and Roth IRAs are great long-term savings tools, so educate yourself on the differences and make an informed decision that fits your retirement goals. If you expect tax rates in the future will rise, either because your wealth and income will be higher when you retire or a change in tax law, consider Roth accounts. Also, be sure to talk with your CPA or tax professional about whether a traditional or a Roth IRA—or both—makes sense for you.
¹If you take a distribution of Roth IRA earnings before you reach age 59½ and before the account is 5 years old, the earnings may be subject to taxes and penalties. You may be able to avoid penalties (but not taxes) in certain situations. If you’re older than 59½ but haven’t met the five-year holding requirement, your earnings may be subject to taxes but not penalties. Consult IRS rules before contributing to or withdrawing money from a Roth IRA.