Choosing Between Traditional and Roth IRAs

Posted on February 26, 2014 at 10:19 AM PDT by

Beginning savers and investors sometimes find the selection of retirement accounts confusing, and with good reason: 401(k)s, 403(b)s, IRAs, 529s, on and on.

Then there are choice within choices. You can open a traditional IRA, roll over money from an old 401(k) into an IRA or simply use a Roth IRA. Which is right for you?

The correct answer is, all of them. The fundamental question in the case of choosing between a traditional and Roth IRA is: When do you want to pay your taxes?

traditional and roth iras

Depending upon your income level and other factors, that answer might be now or later. Let’s dig in a little on the big categories:

401(k) and 403(b) plans

These are the easiest to understand. They are offered by your workplace and give you a tax break today by effectively lowering your income. Money you set aside in a 401(k) or 403(b) is literally subtracted from your taxable pay. You owe zero taxes on those dollars now.

The money then compounds in your favor for decades. You are required, starting at age 70-and-a-half, to begin removing money from these accounts. The amount is an IRS calculation but the point is to collect taxes while you are alive. However, the tax rate is at your ordinary income rate in retirement, which is likely to be lower than while you were working.

Traditional and rollover IRAs

These are the same thing. The difference is the source of the money to fund them. If you move money from a previous employer into an IRA, it is likely to be called a “rollover IRA” by your brokerage or bank. If you put money in directly, it will be referred to as a traditional IRA. Ordinarily, there’s only need for one account, so it’s usually better to roll any old workplace savings into an existing traditional IRA and call it a day.

You might not be able to contribute every year to an IRA, especially if you already contribute the maximum to your workplace 401(k). However, those with a non-working spouse often can contribute earnings to his or her IRA. Consult a tax specialist, as regulations and situations change.

Roth IRAs

Like a 401(k), your traditional IRA is all about reducing tax liability now and letting money compound into the future, where it will be taxed later. A Roth IRA offers you no such immediate break. You must contribute based on earnings that are taxed this year.

Why bother? Well, because you won’t be taxed when you take that money back out in the future. All of the capital appreciation, the dividends earned, the compounding interest — all of it grows inside a Roth IRA tax-free forever. It can be a huge advantage later, especially if you believe your retirement income tax rate might be higher than it is today.

Also, there are fewer restrictions on when you use Roth IRA savings. Some advisors consider it the best “rainy day” fund, since in most cases you can withdraw contributed money prior to retirement without a penalty, if you meet certain requirements. Again, consult a CPA about your situation.