Roth IRA vs. Traditional IRA: What’s the Difference?

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If you’re funding an Individual Retirement Account, your first decision will be a Roth vs. traditional IRA.

But what’s a Roth IRA? And what are the differences between a Roth and a traditional IRA?

In this article, I’ll explain the tax implications, which are the biggest differences between contributing to a Roth IRA vs. a traditional IRA. I’ll also give you some guidance on when each choice makes sense.

Table of Contents

What Is a Roth IRA?

An IRA is an Individual Retirement Account. They’ve been around for almost half a century now. Roth IRAs, which have been available since 1997, hold some similarities to traditional IRAs.

The biggest difference is the treatment of taxes.

When you contribute money to a Roth IRA, you’re putting in money that you have already paid taxes on. When you withdraw money from a Roth IRA in retirement, you won’t owe any taxes on the money you put in or the profit you’ve made.

If you think that taxes will rise in the future, paying taxes now and then taking your money out later — tax free — is a win.

That’s why money expert Clark Howard prefers Roth IRAs over traditional IRAs.

“Remember, in general, tax rates are likely to go higher over the years no matter which political party is in power,” Clark says. “That means it may make more sense to skip the deduction of a traditional IRA now to avoid tax later with a Roth IRA.”

Imagine that Susan and Jim make the same amount of contributions to their IRAs, but Susan has a Roth and Jim has a traditional IRA.

Assuming that their contributions and profits are equal, when Susan and Jim reach the penalty-free withdrawal age of 59½, Susan is going to have more retirement money. That’s because Jim is going to have to pay taxes on his withdrawals.


What’s the 5-Year Holding Period for Roth IRA Accounts?

There are two hurdles you have to clear to withdraw investment earnings from a Roth IRA without penalty:

  1. You must be at least 59½ years old.
  2. Your Roth IRA account must be at least five years old.

That five-year rule is unique to Roth IRAs. How do you know when your Roth reaches its fifth “birthday?” The clock starts on the earliest date of these three events:

  1. The first time you contribute money directly to your Roth IRA.
  2. The day you roll over a Roth 401(k) or 403(b) to the Roth IRA.
  3. The day you convert your traditional IRA to a Roth IRA.

If you’re younger than 59½, and your Roth IRA includes money from multiple conversions, you must track each conversion separately to calculate the five-year holding period.

It is worth noting that while you do have to clear these hurdles to take out your earnings to avoid a hefty penalty, you can take out your principal (the money you put in) at any time penalty-free. That’s not to say you shouldn’t have savings for emergencies, but for some people knowing this is enough to help them start saving for retirement.

Roth IRA vs. Traditional IRA

Best forExpect taxes to rise in the futureExpect taxes to be lower in the future
TaxesGrows tax-free; contributions not deductibleGrows tax-deferred; contributions tax deductible subject to income limits for participants in employer-sponsored plans
ContributionsPost-tax dollarsPre- or post-tax dollars
Contribution limits$6,500/$7,500$6,500/$7,500
Contribution eligibilityEarn income below certain limits*Earn income*
WithdrawalTax-free after 5 years + age 59½^Taxed as income after 59½
Required Min. DistributionNeverAfter 73#
Bottom lineCelebrate future tax-free withdrawalsReduce taxable income + no immediate taxes

*You also can’t contribute more than 100% of your income for the year.

^The 10% early withdrawal penalty applies only to your investment earnings. You can take out your contributions at any time with no penalty.

#You must take your first RMD by April 1 the year after you turn 73. In subsequent years you must take your RMD by Dec. 31.

Let’s cut to the chase. Figuring out Roth vs. traditional IRA comes down to figuring out whether your taxes are going to be higher now or higher when you withdraw the money.

Most people assume their tax brackets will be lower in retirement, and that may be true. But don’t discount Social Security income, income from traditional 401(k) plan withdrawals, income from any consulting or freelance work and the loss of certain tax deductions such as those for dependents or a mortgage.

Clark thinks that almost everyone will pay higher taxes in the future to finance the federal government’s current budget deficits. That’s why he’s so pro-Roth.


Roth vs. Traditional IRA: Similarities

Roth and traditional IRAs do share plenty of attributes:

  • The maximum yearly contribution for any IRA is $6,500 if you’re younger than 50 and $7,500 starting the year you turn 50.
  • Minors can open and contribute to their own IRAs. But they’re limited by their income. Parents can contribute, but total contributions cannot exceed the child’s personal income in any given year or $6,500, whichever is less.
  • The deadline for contributions to both types of IRAs is the income tax filing deadline the following year (typically April 15).
  • There are withdrawal exceptions (penalty-free withdrawals prior to age 59½) for Roth and traditional IRAs. For Roth IRAs, the penalty applies only to the money you earn on your investments, because you’re not taxed on contributions. For traditional IRAs, those exceptions apply to contributions and earnings.

When You Should Choose a Roth IRA

Here’s when a Roth IRA may make more sense for you:

  • You expect that the percentage of your income that you pay in taxes is smaller now than it will be in the future.
  • You’re currently putting in enough money to reach your annual contribution limits.
  • Roth IRAs allow you to avoid Required Minimum Distributions (RMDs) forever. Every other tax-advantaged retirement account requires you to start withdrawing a certain percentage of funds after your 73rd birthday.
  • You want to lower your taxable income in retirement. (Withdrawals from traditional IRAs are taxed and contribute to determining your tax bracket. Roth IRA withdrawals, on the other hand, don’t count towards your tax bracket in retirement because you have already paid the taxes on the principal and your earnings are tax-free.)
  • Your retirement nest egg is going to be larger than it would be if you had to pay taxes when you withdraw.

When You Should Choose a Traditional IRA

Here’s when a traditional IRA may make more sense for you:

  • You’re making a lot of money now, and you expect your tax bracket to be lower in the future.
  • You want to lower your taxable income for the current tax year.
  • You’re not eligible to contribute to a Roth IRA due to your income. And, you have already explored your options for a backdoor Roth IRA.

IRAs vs. 401(k)s

The contribution limits of IRAs are relatively low. You’re allowed to put in $6,500 per year (which works out to $541 per month) if you’re younger than 50. That’s compared to $22,500 per year with a 401(k).

IRAs also don’t allow you to get company matches. That’s one of the major advantages that 401(k) plans offer.

However, you’ll have way more investment options inside of an IRA (including investing via a robo-advisor). You’ll also potentially enjoy lower costs. And you’ll probably experience a lot less hassle in the future, especially if you leave a job where you have a 401(k) plan well before retirement.

Clark recommends that the first thing you do — before opening any type of IRA — is to contribute enough to your 401(k) to get the maximum company match from your employer (if a 401(k) is available to you).

Clark says that unless your 401(k) plan is expensive, you should contribute to your 401(k) up to your annual contribution limit before turning to an IRA.

Things To Do Whether You Invest in a Roth or a Traditional IRA

If you plan to open an IRA, Clark recommends that you do so with one of the Big Three investment firms. That means Fidelity, Schwab and Vanguard.

Whether you choose a Roth or a traditional IRA, Clark says it’s important to:

  • Make contributions to your retirement account each month (or every paycheck). Automate your contributions if at all possible.
  • Increase the amount you’re contributing over time. “Every six months, I want you to increase your contributions by one cent for every dollar you earn,” Clark says.
  • Invest your retirement account money into a target date fund. This is Clark’s favorite investment recommendation.

Final Thoughts

Clark recommends Roth IRAs over traditional IRAs because he thinks that taxes are going to rise in the future.

Just remember that time in the investment market, especially inside a tax-advantaged account, is a powerful force that can help you achieve your retirement goals. That goes for all types of retirement accounts — Roth vs. traditional IRAs and 401(k)s.

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