Traditional vs Roth, What’s the Difference, and Which is Better?
"Should I contribute to a Traditional or Roth?" Ah yes, the age-old question debated since time immemorial, confounding the wisest among us, and pondered only slightly less than “What is the meaning of life?” Well, age-old meaning since 1997 when the Roth IRA was first introduced, and time-immemorial referring back to 2006 when the Roth 401k option began showing up in employer-sponsored plans. Oh, and by wisest, among us I guess I just mean non-tax professionals (no offense, you CPAs out there). But before I give you the elusive answer as to which is better, let’s define our terms.
The first thing to understand is that neither an IRA nor a 401k are an investment product in and of itself – they’re the wrapper, the tax sleeve, so to speak. Within this sleeve, you can allocate your funds to many different types of investments – stocks, bonds, mutual funds, annuities, CDs, gold, real estate, etc. The terms Traditional and Roth refer to different tax-advantaged treatments of the account, and each one has its own set of pros and cons.
Let’s start with Traditional.
Advantages: Contributions made to your traditional IRA can be tax-deductible (depending on your income level and access to an employer-sponsored plan), reducing your current taxable income and taxes owed. You can postpone the realization of these earnings until a later date in retirement when you are expected to be in a lower tax bracket, effectively paying less to the IRS on those earnings.
These contributions also grow tax-deferred, creating a snowball effect on your savings since the interest, dividends, and capital gains are shielded from being taxed from year to year. The IRS doesn’t get to pick your retirement pocket every year on the earnings the account made. Those earnings get to stay in the account and create more earnings themselves. Over time, that means your account can grow faster.
Potential Disadvantages: One thing to keep in mind with traditional retirement accounts is that you will eventually have to start withdrawing those funds via Required Minimum Distributions, or RMDs for short, and all of the proceeds will come as taxable distributions. Depending on how much you saved and how well the markets performed, you may have the enviable problem of having to take out too much income down the road, potentially nullifying the tax advantages you originally realized. Additionally, all of the dividends and capital gains that may have been taxed at lower capital gains rates outside of an IRA will now be taxed at ordinary income tax rates when you withdraw them.
Now, the Roth option:
Disadvantages: Unlike a Traditional IRA, Roth contributions cannot be tax-deductible. They are after-tax contributions made to your retirement account. If you’re trying to stash some funds away and reduce your taxable income for the current year, Mr. Roth isn’t going to help you. However, since you have already paid the taxes on the contributions, you will not owe any taxes on the principal when it is withdrawn.
Advantages: But here’s the beauty of the Roth IRA – as long as you follow the qualified distribution rules of pulling money out of the Roth in retirement, all of the dividends, interest, and capital growth are withdrawn; get this tax-free. This allows for tactical retirement planning via the use of strategic income withdrawals and vehicles such as Roth Conversions, which can reduce your total tax burden.
So, which is better for you? You guessed it – it depends. I know, after all that “wisest among us” talk, you were expecting a more definite answer. Point taken. Hear me out, though. I’m not saying that there isn’t a right answer for you because there is. A good financial planner is able to walk you through the process of building out a long-term strategy, including tax planning and retirement income withdrawal strategies. Everyone’s situation is a little bit different, so don’t make the mistake of relying on an article or blog post to plan your retirement.
Provista Wealth Advisors in Greenville, SC, provides peace of mind through personalized asset management, expert estate planning, and retirement planning. Navigate your financial journey with confidence. Rest Assured, We Have A Plan. Give us a call at (864) 696-2410 or send us a message to schedule your free introduction meeting.