What's the difference between a Roth and Traditional?

Great question! I'm so glad you asked. Let's break it down.

The primary difference between these two types of retirement accounts boils down to when you pay taxes: now or later.

• A Roth IRA is funded with after-tax dollars, meaning you pay taxes up front. Once the money is in the account, it grows tax-free, and you can withdraw it tax-free in retirement.

• On the other hand, a Traditional IRA is funded with pre-tax dollars, so you don’t initially pay taxes. Instead, you pay taxes when you withdraw the funds in retirement. Since you’re deferring the tax payment, contributing to a Traditional IRA can lower your taxable income for the year, giving you a tax break.

But let’s go a little deeper and talk about the details.

Traditional Accounts

Traditional accounts come in several forms, with Traditional IRAs (Individual Retirement Accounts) and Traditional 401(k)s being the most common. A 401(k) is typically employer-sponsored and often includes an employer match (where your employer matches a percentage of your contributions). If your employer offers a match, I highly recommend to contribute at least enough to take full advantage of the full match. For example, if your employer match is 6% of your income, make sure to contribute at minimum 6%—anything less is leaving free money on the table. However, be sure to check your employer’s specific matching terms, as some may match only up to a certain percentage or dollar amount. A major advantage of Traditional accounts is the potential for a tax deduction. However, if you are covered by a retirement plan at work (like a 401(k)), there are income limits that determine if you're eligible for the full deduction. If you are not covered by a workplace retirement plan, these income limits generally do not apply. One disadvantage to Traditional accounts is the RMD (Required Minimum Distribution). Generally, at age 73, you must start withdrawing a minimum amount each year (determined by a distribution factor), and if you fail to do so, you could face a 25% penalty on the amount you should have withdrawn. RMDs can also push you into a higher tax bracket, which is why tax planning is critical as you approach retirement. If you want to learn more about RMD's, I highly recommend you to read my article "Understanding RMDs: Your Playbook for Retirement Withdrawals." Inherited Traditional IRAs have RMD rules as well, meaning your beneficiaries may have to take distributions. If you’ve already started RMDs before passing away, your beneficiaries will continue taking them at your rate, which can sometimes be advantageous. However, if you haven’t started RMDs, your beneficiaries must liquidate the account within 10 years, which could trigger higher taxes for them.

Lastly, since Traditional accounts have tax advantages, they come with contribution limits. For 2024, you can contribute up to $22,500 to a 401(k), with an additional $7,500 catch-up contribution allowed if you’re 50 or older. For Traditional IRAs, the contribution limit is $7,000, with a $1,000 catch-up contribution, making the total $8,000 if you qualify.

Are you having fun yet? Stay with me.

Roth Accounts

A Roth IRA allows you to pay taxes upfront, and once the money is in the account, it grows tax-free. One of the major advantages of Roth IRAs is that they don’t have RMDs for the original owner. However, your beneficiaries will need to withdraw the entire balance within 10 years of inheriting the account unless they qualify for certain exceptions (e.g., spouses). While Roth IRAs don’t require RMDs for the original owner, there are rules about when you can withdraw funds. You can access your contributions (the money you initially contributed) at any time, tax-free and penalty-free, no matter your age. However, if you withdraw earnings (interest, dividends, and gains) before age 59 ½, you could face taxes and a penalty. This distinction is important to keep in mind when planning your retirement contributions—think of your Roth contributions as “locked up for retirement,” especially the earnings. Unlike Traditional IRAs, Roth IRAs don’t offer a tax deduction for contributions. However, the tax-free growth and withdrawals in retirement can be appealing, particularly if you expect to be in a higher tax bracket later in life. Roth IRAs are a relatively new option, introduced in the 1980s, so many older savers didn’t have access to them when they first began their careers and started saving. As a result, some retirees now face higher-than-expected taxes from RMDs on their Traditional IRAs, which could have been mitigated had they had access to Roth accounts earlier in their careers. As with Traditional accounts, Roth IRAs have contribution limits. For 2024, you can contribute up to $7,000 to a Roth IRA, with an additional $1,000 catch-up contribution allowed for those aged 50 or older, for a total of $8,000.

My Two Cents: When choosing between a Traditional and Roth IRA, it’s crucial to consider your personal financial situation. If you expect to be in a lower tax bracket in retirement, a Traditional IRA may make sense. If you’re in a lower tax bracket now but anticipate being in a higher bracket later, a Roth IRA could make more sense.  And remember, these accounts aren’t mutually exclusive—you can have both a Traditional and Roth account, contributing to each up to the contribution limit.