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Roth or Traditional IRA: Which is Best for Me? Thumbnail

Roth or Traditional IRA: Which is Best for Me?

When you’re saving for retirement, both Roth and traditional IRAs can be great options to save into. Each of these two account types has different advantages and disadvantages. When deciding which is best for you, it all depends on your situation. 

Similarities Between Roth IRAs and Traditional IRAs

Both Roth IRAs and traditional IRAs are types of accounts with unique tax benefits. The primary use of these types of accounts is to set money aside to be used in the future in retirement (or at least later in life).

You can think of each of these accounts as a bucket. You can choose which investments to put in the bucket (such as stocks, bonds, cash, mutual funds, etc.) regardless of whether it’s a Roth IRA or a traditional IRA. One of the main tax benefits of these accounts is that as long as the money is in the account, any growth on those investments is tax-free, even if you sell investments that have a gain in them. In other words, you can change around the investments you have in the bucket as much as you want without any tax implications. There are only tax implications when you take the money out of the bucket. 

Another similarity between the two accounts is that you (or your spouse) have to have earned income in order to contribute to one. There are also limits on how much you can contribute. For 2023, you can contribute up to your earned income or $6,500, whichever is less. The limit is increased by $1,000 for those age 50 and over.

What Is Unique to Roth IRAs?

The big difference between the two accounts is their tax treatment. Contributions to Roth IRAs do not offer an upfront tax benefit or deduction. Instead, you get the main tax benefit when withdrawing from the account because any withdrawals after age 59 ½ are free of taxes or penalties. In essence, you forego a current tax benefit for an expected tax benefit in the future. 

Any amount that you have contributed to a Roth IRA can be withdrawn at any time and at any age without taxes or penalties. It is the earnings that, if withdrawn, would trigger taxes and penalties unless there is an exception. Some available exceptions include a first home purchase, college expenses, and birth and adoption expenses.

What Is Unique to Traditional IRAs?

The tax treatment of traditional IRAs is basically the opposite of that of Roth IRAs. You get a tax deduction when you make contributions to a traditional IRA account and then when you withdraw the money after age 59 ½ it counts as taxable income to you. 

Traditional IRAs do not offer a way to access any funds in the account prior to age 59 ½ without incurring taxes and penalties unless an exception applies. Like Roth IRAs, some available exceptions include a first home purchase, college expenses, and birth and adoption expenses. 

Also, traditional IRAs are subject to Required Minimum Distributions (RMDs). This is a requirement from the IRS to withdraw a portion of the account balance every year after reaching a certain age. RMDs currently start at age 73 but are set to change to age 75 in 2033. Currently, for the majority of IRA account owners, the first RMD amount at age 73 is equal to roughly 3.8% of the account balance, and the percentage increases each year. 

Which Account Is Right for Me? 

While they serve the same general purpose, you can see that there are some key differences between Roth IRAs and traditional IRAs. Determining which account is right for you often comes down to which tax benefit would be more beneficial for you. Remember that with Roth IRAs, you get the tax benefit when you withdraw money from the account later in life. With traditional IRAs, you get the tax benefit right away when you contribute. 

In general, you want to get the tax benefit when you are paying higher tax rates. If you are paying high tax rates now (maybe you’re in your peak income-earning years) and you expect to have lower tax rates in retirement, then a traditional IRA may make sense. If you’re paying lower tax rates today (maybe you’re early in your career or only working part-time) and you think your tax rate may be higher during your retirement, then a Roth IRA could make more sense for you. Which makes the most sense can change over your lifetime depending on the season that you are in. The chart below from Kitces.com illustrates how your tax situation can change over time and some of the things that could drive it. 

In most cases you won’t know for sure what tax bracket you will be in during retirement, so you just need to make your best estimate. Keep in mind that in retirement you will still have taxable income even if you are no longer working. You may have income from Social Security, withdrawals from traditional IRAs or tax-deferred work retirement plans (e.g. tax-deferred 401(k) plan), pensions, or other sources. Also, keep in mind that Roth IRAs have a few additional benefits, namely tax and penalty-free withdrawals of your contributions at any time and not being subject to RMDs.  

How We Can Help

When making the Roth versus traditional IRA decision, it helps to look at it in the context of your entire financial picture. How do your other goals and your tax situation affect the decision? If you aren’t sure how all of the pieces of your financial life fit together, then you would greatly benefit from a comprehensive financial plan. Our comprehensive financial plans look at every area of your financial life, from retirement to taxes to cash flow, etc. And we write them so that you can understand and implement them on your own if you want to. To learn more about how we can help you build a plan for your entire financial life, schedule a free introductory phone call today. 

About Guide Financial Planning

Guide Financial Planning is led by founder Ben Wacek, who is a Christian fee-only Certified Financial Planner™ and Certified Kingdom Advisor®. He has a passion to help people of all income levels make wise financial decisions and steward their resources from an eternal perspective using Biblical principles. Based in Minneapolis, MN, he works with clients both locally and virtually throughout the country and abroad. You can follow the links to learn more about Guide Financial Planning and our team and the services we offer.