Download the Schwab app from iTunes®Close

Roth vs Traditional IRAs: Which Is Right for Your Retirement?

Note: Due to the Coronavirus Aid, Relief, and Economic Security (CARES) Act, required minimum distributions (RMDs) for IRAs are waived for 2020. Learn about the RMD waiver > 

Both traditional and Roth IRAs can be effective retirement savings tools, but eligibility limitations mean one or both may not be right for you. Here’s a guide to help you choose.

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.¹ This makes a traditional IRA an attractive option for investors who expect to be in a lower tax bracket during retirement than they are now.

On the other hand, Roth IRA contributions are made with after-tax dollars. The benefit of a Roth IRA is that you can withdraw your contributions and earnings tax-free after age 59½, if you’ve had the account for at least five years, or you meet certain other conditions.² In addition, your after-tax contributions to the Roth account can be withdrawn at any time, tax- and penalty-free. However, if you make an early withdrawal of any earnings, you will have to pay taxes and penalties on them.

A Roth IRA could be a strategic option for investors who expect to be in a higher tax bracket during retirement than they are now. It can also offer some spending flexibility in retirement, since you can withdraw money without increasing your tax bill and you won’t have to take annual required minimum distributions (RMDs), unlike a traditional IRA.

How much can I contribute?

The maximum amount you can contribute across all your IRAs (traditional or Roth) in 2020 is $6,000. The catch-up contribution if you’re age 50 or older remains $1,000. However, there are some rules that affect IRA contributions and deductibility.

For example, there is no income limit for contributing to a traditional IRA, and your contribution is fully deductible if neither you nor your spouse was covered by a retirement plan at work during the tax year. However, if either of you was covered by a workplace retirement plan, deductibility phases out depending on your filing status and income.

Contribution deduction eligibility for traditional IRA

Filing status (2019 tax year) Fully deductible if income is: Partial deduction if income is: No deduction if income is:
Single ≤ $64,000 > $64,000 but < $74,000 ≥ $74,000
Married filing jointly, filer is covered ≤ $103,000 > $103,000 but < $123,000 ≥ $123,000
Married filing jointly, spouse is covered ≤ $193,000 > $193,000 but < $203,000 ≥ $203,000
Married filing separately NA < $10,000 ≥ $10,000

 

Filing status (2020 tax year) Fully deductible if income is: Partial deduction if income is: No deduction if income is:
Single ≤ $65,000 > $65,000 but < $75,000 ≥ $75,000
Married filing jointly, filer is covered ≤ $104,000 > $104,000 but < $124,000 ≥ $124,000
Married filing jointly, spouse is covered ≤ $196,000 > $196,000 but < $206,000 ≥ $206,000
Married filing separately NA < $10,000 ≥ $10,000

Source: Internal Revenue Service

Unlike with a traditional IRA, you can only contribute to a Roth IRA if your income meets certain limits.

Income eligibility for Roth IRA contributions

Filing status (2019 tax year) Full contribution allowed if income is: Partial contribution allowed if income is: No contribution allowed if income is:
Single < $122,000 ≥ $122,000 but < $137,000 ≥ $137,000
Married filing jointly < $193,000 ≥ $193,000 but < $203,000 ≥ $203,000
Married filing separately NA < $10,000 ≥ $10,000

 

Filing status (2020 tax year) Full contribution allowed if income is: Partial contribution allowed if income is: No contribution allowed if income is:
Single < $124,000 ≥ $124,000 but < $139,000 ≥ $139,000
Married filing jointly < $196,000 ≥ $196,000 but < $206,000 ≥ $206,000
Married filing separately NA < $10,000 ≥ $10,000

Source: Internal Revenue Service

 

If you qualify for both accounts, how do you choose which one to contribute to?

If you think your tax bracket will be higher when you retire than it is today, you may want consider a Roth IRA—especially if you’re younger and have yet to reach your peak earning years.

Traditional vs. Roth IRA: Impact of tax bracket at retirement on savings

If your tax bracket is expected to be lower in retirement, then a traditional IRA may give you a higher end balance than a Roth IRA.

Calculations assume a pre-tax contribution of $5,000 in the traditional IRA and a post-tax contribution of $3,750 in the Roth IRA, taxed at a 25% marginal tax rate. The hypothetical balance assumes a 6.5% average annual return over 25 years. The tax at withdrawal for the traditional IRA assumes a 30%, 25%, and 20% marginal income tax rate, respectively. 

If you think your tax bracket will be lower when you retire, you may be better off taking the up-front deduction of a traditional IRA. If you think your tax bracket will be the same when you retire, it’s almost a wash for income tax purposes.

There are a few other advantages to a Roth IRA worth considering. You aren’t subject to RMDs with a Roth IRA, and it can be a flexible source of retirement funding. For example, you can withdraw a large sum if you have a one-time expense or other needs in retirement without increasing your tax bill. Allocating a portion of your retirement savings to a Roth IRA can increase the flexibility you have to manage taxes in retirement.

You can withdraw contributions anytime for any reason without tax or penalty. However, just because you can doesn’t mean you should. The opportunity costs are high—taking money out of your Roth IRA means you may miss out on the potential for compounding gains. And when you can put in only $6,000 for 2020 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 with certainty future tax rates. 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

Account rollovers

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 pretax contributions and earnings at the time of the rollover. Also, remember that you may have other options, including keeping your assets in your former employer’s plan, rolling over assets to your new employer’s plan, or taking a cash distribution (on which taxes and possible withdrawal penalties may apply).

Roth 401(k)

An increasing number of employers are offering 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 pretax 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). 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 this by rolling over a Roth 401(k) balance into a Roth IRA before your RMD age. So 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, some investors maximize contributions to a traditional IRA so they can convert to a Roth IRA. However, there are some caveats.

You can’t pick and choose which portion of traditional IRA money is converted. The IRS looks at all traditional IRAs as one when it comes to distributions, including 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 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, which, as always, is best paid with outside funds.

High earners not 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”). The process is similar to any other Roth conversion, but typically takes place very soon after contributing funds to a traditional IRA. There is some debate among tax professionals whether this conversion conflicts with the intent of the Roth conversion law, which was updated in 2010. The IRS has not formally weighed in on this topic, so beware that there may be some risks to this strategy. If the IRS decides to question the conversion, you may owe a 6% tax or other taxes for overfunding your Roth. For some investors, a backdoor Roth conversion could be a viable way to obtain the benefits of tax-free growth, as long as they’re comfortable with the potential uncertainty and work with a certified public accountant (CPA) or tax professional.

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 with your retirement goals. Remember that tax laws are subject to change, so keep up with the latest news from the IRS. 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 withdraw money from a traditional IRA before age 59½, your deductible contributions and earnings (including dividends, interest, and capital gains) will be taxed as ordinary income. You may also be subject to a10% penalty on early withdrawals, and a state tax penalty may also apply. Consult IRS rules before contributing to or withdrawing money from a traditional IRA.

²If you take a distribution of Roth IRA earnings before you reach age 59½ and before the account is five 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.

What you can do next

All Right Now: But a Long Way to Go to Recover
Why Consider a Roth IRA Conversion and How to Do It
null

Important Disclosures

The information and content provided herein is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, or legal, tax, or investment advice, or a legal opinion. Individuals should contact their own professional tax advisors or other professionals to help answer questions about specific situations or needs prior to taking any action based upon this information.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

The type of accounts mentioned and the investment strategies may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

Investing involves risk, including loss of principal.

A rollover of retirement plan assets to an IRA is not your only option. Carefully consider all of your available options which may include but not be limited to keeping your assets in your former employer's plan; rolling over assets to a new employer's plan; or taking a cash distribution (taxes and possible withdrawal penalties may apply). Prior to a decision, be sure to understand the benefits and limitations of your available options and consider factors such as differences in investment related expenses, plan or account fees, available investment options, distribution options, legal and creditor protections, the availability of loan provisions, tax treatment, and other concerns specific to your individual circumstances.

When a participant rolls a Roth 401(k) balance to a new Roth IRA, the fiveyear qualification period starts over. This may impact the rollover decision. If the participant has an established Roth IRA, then the qualification period is calculated from the initial deposit into the IRA and the rollover will be eligible for taxfree withdrawals when that fiveyear period has ended (and the age qualifier has been met).

Each Roth conversion has a separate five-year holding period for determining withdrawal penalties.

Roth IRA conversions require a 5-year holding period before earnings can be withdrawn tax free and subsequent conversions will require their own 5-year holding period. In addition, earnings distributions prior to age 59 1/2 are subject to an early withdrawal penalty.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

(0720-0CT0)

Thumbs up / down votes are submitted voluntarily by readers and are not meant to suggest the future performance or suitability of any account type, product or service for any particular reader and may not be representative of the experience of other readers. When displayed, thumbs up / down vote counts represent whether people found the content helpful or not helpful and are not intended as a testimonial. Any written feedback or comments collected on this page will not be published. Charles Schwab & Co., Inc. may in its sole discretion re-set the vote count to zero, remove votes appearing to be generated by robots or scripts, or remove the modules used to collect feedback and votes.