Traditional vs Roth- Which is Better?
So, which is better? Roth or Traditional contributions to your retirement plan? It depends. There are variety of savings and investment strategies because people are different; their situations are different; their goals are different. That’s good because that means you have options. I’m not going to try to convince you that one is better than the other, but to clarify the difference so that you can make a more informed decision if this information is new to you.
Let’s clarify a few things first. One, this subject has to do with retirement monies, although there are many savings and investment opportunities outside the scope of retirement.
The money you (and your employer) put into your retirement account are called contributions. There are primarily two vehicles used to store your retirement monies. One is a 401K plan with your employer. Your employer deducts money from your paycheck to contribute towards your retirement. Your employer can match contributions as well. The other primary way to save for retirement is through an Individual Retirement Account (IRA). This plan, you can start outside of your employer, for any reason. You can have one or the other or you can have both. Your employer may offer a 403b if you work for a tax-exempt agency like a school. You may also have an SEP, if you are self employed or work for a small business. I’ll be focusing on the 401K and IRA.
Whether your retirement savings is with your employer (401K) or individual retirement account (IRA), your deposits can be either Traditional, Roth, or a combination. You can mix and match as long as you play by the rules. The primary difference between the Traditional and Roth is how they are taxed.
HYPOTHETICAL SCNENARIO
Traditional contributions are deposited tax free while working. You pay taxes on your contributions and the growth, as you withdraw them in retirement. The growth is based on how much interest you received while that money was just sitting there.
Example: You earn $2,000, contribute 5% ($100), you do not pay taxes on the $100, right now. The full $100 is deposited.
If you contributed $100/month for 25 years, your personal deposits would total $65,000. In retirement, you now owe taxes on your $65,000 personal deposits and the potential $455,000 growth (for a total of $520,000).
Con: You pay taxes on all of your $520,000 withdrawals.
Pro: You will likely be in a lower tax bracket in your retirement versus a higher tax bracket while still working.
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Roth contributions are deposited after tax. That means, a lesser amount is being deposited. You pay taxes now, so you do not have to pay taxes at retirement. In exchange, all the growth on your money (potentially over decades), is tax-free when you withdraw it in retirement.
Example: You earn $2,000, contribute 5% ($100), you pay taxes on that $100 contribution, now and the difference that is deposited into your account may only be $90 (versus $100).
If you contributed $100/month for 25 years, your personal deposits would total $58500. You would owe no additional taxes on that $58,500 because you already paid taxes on it. You would owe no taxes on the potential $409,500 growth.
Con: You will likely be taxed at a higher rate because you are working.
Con: Your account will grow at a slower rate because contributions are taxed.
Pro: You do not pay taxes on any of your $468, 000 withdrawals. You already paid taxes on your personal contributions while you were working, and the growth is tax free earnings.
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You can mix and match your contributions if you chose, as long as you play by the rules. In fact, if your employer contributes to your 401K (i.e., through an employer match program), all their contributions are traditional, regardless as to whether your own contribution is Traditional or Roth. You will pay taxes on their contribution and growth, no matter what. No worries, this was free money anyway.
Also keep in mind that there are maximum contribution limits based on your age, required minimum distribution age requirements and amounts, potential penalties for early withdrawals with a few exceptions, etc. You can read more about it at Retirement Plans | Internal Revenue Service (irs.gov).
Conclusion
Taking an active role in planning for your retirement is one of the wisest things you can do. It can be as simple as participating in your employer’s retirement program and/or starting your own individual retirement account. You can develop your strategy as you learn and grow. You can also seek advice from your tax accountant or certified financial expert, if you prefer.
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All information in this post is strictly educational and should not be used as financial advice for your individual circumstance.
