Investing Basics: Traditional vs. Roth IRAs

Posted on February 5, 2014 at 10:06 AM PDT by

One of the most confusing aspects of retirement saving is the proliferation of tax-deferred retirement accounts. There are specialized health and education accounts, individual retirement accounts of various flavors, then a wide variety of potential investments to put inside them.

You can be forgiven if “grocery aisle paralysis” sets in. Too many choices is a real problem, one the retirement industry tends to address by offering even more choices. Like a shopper contemplating 15 varieties of toothpaste, we often go with the tried-and-true or simply give up and walk away.

roth iras

Giving up is the problem. We don’t save nearly enough and we don’t save in the smartest possible ways. So here’s a simple breakdown of two major individual retirement account types — traditional and Roth IRAs.

They have a lot in common, but they are different in one major way. A traditional IRA is for money you save today in order to delay taxes. A Roth IRA is for money on which you will pay taxes today but wish to use in the future tax-free.

Both have advantages. Let’s drill down (no pun intended) a little more:

Traditional IRA: You can put aside money today, within certain limits, and avoid paying taxes this year. The advantages are twofold: Your money will grow more since more of it will be compounding over a period of years.

You are taxed on the money later at ordinary income rates (not capital gains rates), but only on withdrawals in retirement and probably in a lower tax bracket. You are required to make those withdrawals starting at age 70-and-a-half.

Roth IRA: Like with a traditional IRA you put aside money today but cannot deduct the contribution against current-year taxes. It will compound over years in the same way, but the Roth money does so tax-free.

With a Roth, you pay no income taxes on withdrawals nor capital gains taxes. There are fewer restrictions on timing of withdrawals, too, although high earners are limited in their contributions.

You might hear an advisor talk about a “rollover IRA.” That’s nothing more than money you take from a past 401(k) plan and put into a traditional IRA. You might do that to consolidate your finances into a smaller number of accounts or to make sure that your portfolio is managed in a consistent way.

About Roth conversions

You could just as easily roll 401(k) money (or other IRA savings) into a Roth IRA. However, you would be taxed on the amount you choose to move at current income rates.

That might be a good idea if you are young and can recover the tax cost through market appreciation. It might not if the tax cost today is significant or if you are a near-retiree. A financial advisor can walk you through the impact of a so-called “Roth conversion.”

The bottom line is this: Traditional and rollover IRAs are the same thing, a bucket of money you save today that lowers current taxes. A Roth IRA is there to help you avoid taxes in the future.