Retirement | June 10, 2021

Roth vs. Traditional IRAs: Which Is Right for You?

An individual retirement account (IRA), either a traditional or a Roth, can be an effective retirement savings tool, but eligibility and contribution 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, you can withdraw after-tax contributions to a Roth account anytime, tax- and penalty-free. However, if you make an early withdrawal of any earnings, you must 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 flexibility to manage the combination of paying taxes and spending in retirement because 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 2021 is $6,000, increasing by $1,000 to $7,000 annually 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.

Contribution deduction eligibility for traditional IRA
Filing status (2021 tax year) Full deduction if income is: Partial deduction if income is: No deduction if income is:
Single ≤ $66,000 > $66,000 but < $76,000 ≥ $76,000
Married filing jointly, filer is covered ≤ $105,000 > $105,000 but < $125,000 ≥ $125,000
Married filing jointly, spouse is covered ≤ $198,000 > $198,000 but < $208,000 ≥ $208,000
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 (2021 tax year) Full contribution allowed if income is: Partial contribution allowed if income is: No contribution allowed if income is:
Single < $125,000 ≥ $125,000 but < $140,000 ≥ $140,000
Married filing jointly < $198,000 ≥ $198,000 but < $208,000 ≥ $208,000
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 to consider a Roth IRA—especially if you’re younger and have yet to reach your peak earning years. The table below compares the hypothetical ending balances after a lump sum withdrawal in retirement for higher and lower post-tax tax rates based on a 25% marginal tax rate on the noted contribution amounts.

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.

Also, you can withdraw contributions anytime for any reason without tax or penalty. However, just because you can doesn’t mean you should. 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

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 pre-tax contributions and earnings 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).

Roth 401(k)

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). 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 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”). The process is similar to any other Roth conversion but typically occurs immediately after contributing funds to a traditional 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 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. Remember that tax laws are subject to change, so keep up with the latest news from the IRS. 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 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 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.

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