When people say Roth and Traditional, they are referring to tax advantaged retirement accounts. There are Roth IRAs and 401(k)s and Traditional IRAs and 401(k)s. What exactly are the differences and which one is right for you?
What is an IRA?
An IRA is an Individual Retirement Account. Anyone who pays income taxes/files a tax return can open an IRA account. There is no minimum age and the account has nothing to do with your employer.
In 2021, the maximum amount you are allowed to contribute to an IRA is $6,000 if you are under 50 years old or $7,000 if you are 50 years of age or older.
Here is where things can get a little confusing…
Let’s say you are 16 years old and want to open an IRA. You make $3,000 at a part-time after school job. In this scenario, the maximum amount you are allowed to put into your IRA for the year is $3,000.
What this means is that if your taxable compensation for the year is less than the $6,000 then you can only contribute up to the amount of your taxable compensation.
What is a 401(k)?
A 401(k) is a defined contribution pension retirement plan through your employer. You, as the employee, manage the account and decide what to invest in, how much to invest, and how much risk you want to take. You bear the responsibility of saving for your own retirement.
In 2021, the maximum contribution in an employer sponsored 401(k) is $19,500 for those under 50 years old. The catch-up contribution limit for those 50 years or older is an additional $6,500. This amount does not include your employer match.
What is an Employer Match?
Oftentimes your employer will have a matching program that looks something like this:
Your Company will contribute 1% of your salary for every 2% that you contribute up to a maximum of 3%
Let’s break this down.
If you make $50,000 per year and you decide to contribute 6% of your annual salary to your 401(k), then you will save $3,000 per year ($50,000 * 6%). Under your Company’s policy, they will contribute $1,500 for the year. That means you are saving $4,500 – $3,000 of your money plus $1,500 from your employer.
You will often hear that the bare minimum you should contribute to a 401(k) at least enough to receive the full employer match. This is because your employer match is like getting free money. Who want’s to turn away free money?
For both IRAs and 401(k)s, you must be 59 1/2 years old to withdraw the funds penalty free.
What is a Traditional IRA and 401(k)
In a Traditional IRA and 401(k), the amount of money you contribute to the account is not taxed in the year it is earned. All interest, dividends, and capital gains accumulate in the account un-taxed (money will grow tax free).
but we all know Uncle Sam will come knocking someday…
When you withdraw the funds from the account, the amount you withdraw is now taxable income. You are taxed on the money you contributed (principal) plus all of the earnings that accumulated through the years.
Some Additional Complexities
There are phase-out limits for how much of your Traditional IRA contribution you can deduct depending on your income and how you file your taxes.
In 2021, if your MAGI (modified adjusted gross income) is $65,000 or less, you can take the full deduction. However, if you earn more than $75,000, you will not be able to deduct any of your traditional IRA contributions. If you are somewhere in-between, you will be able to take a partial deduction.
Roth IRAs and 401(k)s
In a Roth IRA, the amount of money you put into the account is taxed in the year it is earned. Since you contribute after-tax dollars, all interest, dividends, and capital gains accumulate tax free. This means, when you withdraw the funds, the amount you withdraw is not taxable because you already paid the tax.
Some Additional Complexities
Similar to Traditional IRAs, the complexities lie in their tax advantages. There are income phase-outs for Roth contributions. In 2021, the AGI (Adjusted Gross Income) phase-out for tax-payers making contributions to a Roth IRA is $196,000 – $206,000 for married filing jointly and $124,000 – $139,000 for single and head of household. This means, if you are married filing jointly the amount you contribute starts decreasing if your tax returns show an AGI of $196,000. Once your AGI goes above $206,000, you are no longer eligible to contribute to a Roth IRA account. The same holds true for those single/head of household.
A Very Special Feature of Roth IRAs
The very special feature of Roth IRA accounts is that after 5 years you can withdraw the principal amount without penalty, regardless of your age. Additionally, you do not pay taxes on that withdrawal because you already paid them!
However, just because you can do something does not mean you should do it. When you withdraw the principal (your contributions) that money cannot go back into the account. Therefore, you lose all future earnings which is substantial.
Which one is better Roth or Traditional?
Assuming you are eligible take full advantage of the tax benefits for each account, which should you choose?
- Determining which type of retirement plan is the better investment requires you to know something that is inherently unknowable.
- Given the choice, you always want to pay taxes on your income when the tax rate is the lowest.
- This means, if your average tax bracket during your working career is higher than your average tax bracket in retirement, you are better off with a Traditional 401(k)/IRA.
- If your average tax bracket in retirement is higher than in your working career, then you are better off with a Roth 401(k)/IRA.
The question is, what are taxes going to be in the future? What is your income going to look like in the future?
The answer is that no one knows.
This is where personal finance gets its name – because it is personal.
Do your research and find out what works best for you!