Roth versus traditional IRA

If you tally the total cost of your retirement, it's probably the biggest bill you'll ever pay. It may also be your goal with the longest lead time.

An important tool to help save for retirement is an individual retirement account. There are two popular types of IRAs: Roth and traditional. Each offers its own tax benefits and is worth considering when retirement planning.

To help determine what works for you, let's first cover the basics. Then we'll dive into an analysis that compares Roth and traditional IRAs through some examples.

IRA basics

An IRA is an account that holds assets like cash, stocks, bonds, mutual funds and exchange-traded funds (ETFs). IRAs are meant to help you save for retirement and offer various tax benefits depending on which type you choose.

Think of an IRA as a garage. A garage may hold a motorcycle, minivan, sports car or bicycle. Just like the vehicles in a garage, the assets kept in an IRA can help achieve a retirement goal but at differing speeds and with varying risk levels.

The biggest difference between Roth and traditional IRAs is whether taxes are paid when the contribution is made, or later, when the money is taken out.

Roth versus traditional IRA

With a Roth IRA, contributions are taxed. However, earnings grow tax free, and withdrawals aren't taxed as long as certain requirements are met.

With a traditional IRA, contributions may be tax deductible, depending on income level. A tax-deductible contribution to an IRA can lower taxable income.

Traditional IRA contributions grow tax-deferred, meaning taxes are not due until money is withdrawn from the account.

Contributions to IRAs

Contributions to an IRA must be from earned income, which is money made from working or running a business. IRA contributions can't be with passive income, which includes earnings from investments, Social Security or pensions. This means that even children who have earned income from a part-time job, or even babies who earn money from modeling, can contribute to an IRA.

Both Roth and traditional IRAs have yearly contribution limits. The limits may differ depending on age and income, so check the IRS website for the most current information about contribution limits.

There are also income limitations preventing certain high-income earners from contributing to Roth IRAs. These limits can change from year to year, so check with the IRS for the most current figures.

Other retirement IRA considerations

Withdrawal restrictions

Although there are some exceptions, you're generally restricted from taking money out of an IRA until age 59½.^{See note1} If you take it sooner, you'll pay a penalty for early withdrawal. Roth IRA contributions can always be accessed since that money has already been taxed. However, a penalty can apply on the earnings if the Roth IRA is less than five years old and you're not yet 59½.

Early distribution exceptions apply for people who become permanently disabled, first-time home buyers, and military reservists called to active duty, among others. If you need your IRA money early, first check to see if any exceptions apply.

Required minimum distributions

The rules for required minimum distributions, or RMDs, have changed over the years and, once again, with the newer Secure 2.0 Act of 2022. Now, under Secure 2.0 Act of 2022, the RMD age is 73 for account owners born in 1951 through 1959. For those born in 1960 or later, the RMD age will become 75.

Since the original Roth IRA owner is not subject to RMDs, this allows for more flexibility in retirement and estate planning. If a Roth IRA holder continues earning a part-time or passive income during retirement, they can leave their money in the Roth IRA and either use it later or even pass it on to a selected beneficiary upon death. Although any remaining amounts in a Roth IRA after the owner's death are subject to RMDs, the distributions are tax free.

Although Roth IRAs do not have RMDs, they do have a rule preventing owners from taking distributions until they've owned the account for five years — another reason to start planning early.

Roth versus traditional IRA tax differences

Roth and traditional IRAs offer tax advantages for long-term savings, but the benefits differ.

When deciding if a Roth or traditional IRA is right, it's important to consider your:

1. Time horizon.
2. Investing style.
3. Anticipated tax rate change in retirement.

When a larger percentage of the account balance is made up of growth, a Roth begins to be more favorable. This is the case of those with longer time horizons and those with more aggressive investment styles, both of which can lead to more growth in the account. With a less aggressive investing style or a shorter time horizon, which tend to have less anticipated growth in the account, the value of a traditional IRA becomes more apparent.

When it comes to tax rates, the larger the drop is from current tax rate to retirement tax rate lends more toward the traditional IRA. For example, a high earner who is currently taxed at 25% but expects retirement income to be taxed at 10% might consider a traditional IRA to defer paying taxes until they're in a lower tax bracket.

On the other hand, if there is not a big drop expected, retirement taxes or tax rates might even increase in the future and a Roth might become more favorable.

As you can see, it can quickly become a guessing game of scenarios. Therefore, we've created a few examples to illustrate the benefits of the different IRAs to help guide the decision. It's important to note that these are just examples to illustrate some key points to understand. Discuss it with a qualified financial advisor to run these types of scenarios with your personal situation and assumptions.

Example A: 20-year timeframe with 25% effective tax rate during working years and 10% in retirement

Meet Anna and Paul. They both earn the same income and contribute $6,000 per year to an IRA that's earning a 6% return. They begin saving at age 45 with plans to retire at age 65. Anna contributes to a traditional IRA and Paul to a Roth IRA.

Since they contribute and earn the same amount over the 20-year period, their IRAs end up with the same final value, more than $220,000. But there's a big difference in how much tax they pay — and when they pay it. Also, in these examples, we're not factoring the time value of money considerations when taxes are paid.

Since her traditional IRA contributions are tax deductible, Anna lowers her annual tax payment by $1,500 each year ($6,000 multiplied by 0.25%), which equals a $30,000 tax savings over the 20 years. When Anna withdraws her money, she pays 10% taxes on the entire balance, which totals just over $22,000.

By investing in a traditional IRA and taking advantage of the upfront tax deductions, Anna has saved almost $8,000 in taxes on her final retirement balance.

Paul receives no tax breaks for his Roth IRA contributions, so he pays $30,000 in taxes on his Roth IRA contributions. But since he doesn't pay taxes when he withdraws the money, his tax bill stays at the $30,000 paid in the past.

In this case, when accounting for Anna's tax deduction and her account being taxed at a lower tax rate, Paul pays approximately $37,000 more in taxes than Anna.

This illustrates the case that in shorter time horizons or when you have a large drop in tax rate at retirement, a traditional IRA tends to be more favorable.

This example may make the traditional IRA seem like a no-brainer, but examples B and C show how things change when tax rates are closer and when there's more time for earnings to accumulate.

Example B: 20-year timeframe with 25% effective tax rate during working years and 20% in retirement

This example shows that the closer the tax rates between earnings and retirement years are, the more the benefits lean closer the Roth IRA due to the decrease value of the upfront tax deduction.

At the 25% effective tax rate, Anna's tax savings is the same as in Example A at $30,000 over 20 years. Now that she's at a 20% effective tax rate in retirement, she'll pay $44,034.71 in taxes on the final account balance leaving her with a total tax bill of $14,034.71.

Paul paid the same taxes as he did in example A. However, the difference between Anna and Paul has decreased to just over $15,000 down from $37,000, illustrating that the closer the tax rates are during your working and retirement years, the advantage of the traditional IRA begins to disappear.

Example C: Same tax rates as Example B but with a 40-year time frame

Now let's repeat Example B but instead of beginning to save at 45, both Paul and Anna start saving for retirement when they're 25.

This example shows that Roth IRAs tend to be more favorable to those who are younger and have longer time horizons, as there's greater potential for growth due to the principal of compounding.

In this scenario, Anna receives the $1,500 annual tax deduction for 40 years, saving $60,000 in taxes during that time. When she pays her 20% tax rate on the final account balance of over $928,000, she pays approximately $185,000 in taxes. This leaves her with a total tax bill of just over $125,000.

Since Paul is taxed only on contributions, he pays $60,000 in taxes. In this case, Paul pays approximately $65,000 less in taxes than Anna. Also, Paul has increased flexibility in retirement since he isn't required to take RMDs, and he can freely withdrawal from his Roth IRA in retirement without worry of being bumped up into a higher tax bracket.

As these examples show, the decision between Roth or traditional IRA can quickly change based on each person's unique situation and assumptions. Changes in tax bracket, time horizon or growth rate can lead them toward one over the other. Also, none of us know what tax rates will be in the future, so it can be hard to make a "perfect" decision – so don't worry about being perfect. For these reasons, and because you never know what the future holds, it's important to Start saving for retirement early.

For some, it might even be a good idea to "hedge their bets" by breaking up the $6,000 yearly contribution and putting $3,000 into each. Either way, they'll accomplish what many people do not, which is saving for retirement. Hopefully, this will help them enjoy the peace of mind that comes with financial security during retirement.