Roth vs Traditional? Retirement accounts, in general, are tax-advantaged accounts that allow you to save for your retirement and hold stocks, bonds, or other investment vehicles inside of them.
Once you open them, you have to choose your investment options and start contributing money, hopefully, every paycheck. (Super Simple Investing)This will allow your money to grow throughout your working years so that you have a nice nest egg to live off of in retirement.
But what’s the difference between a Roth vs Traditional Retirement Account you may ask?
Well, it’s all about how those tax advantages are administered.
Now, I know this is a super dry and confusing topic, so hang in there with me as I break down the differences between a Roth vs Traditional Retirement Account.
Traditional Retirement Accounts
When people think of a retirement account, they often think of a Traditional retirement account first.
With a traditional retirement account, you put in pre-tax dollars.
This can be through an employer-sponsored plan at work, like a 401k or an IRA (Individual Retirement Account) that you open on your own through a brokerage firm like Vanguard or Fidelity.
I will go more into the difference between employer-sponsored and IRA accounts in another post, both work about the same for the purpose of this comparison.
What do pre-tax dollars mean?
When you get paid, your employer takes taxes out of each check and pre-pays your taxes for you. The money you get after the taxes are paid (your paycheck) is your after-tax dollars.
In the spring, you file your taxes and make sure the right amount was pulled out and pay the difference or get a tax refund. (How taxes work.)
Example:
How Your Paycheck Works WITHOUT Traditional Retirment Contributions:
- Your pay check is $1,200
- Your employer takes 20% out for taxes, ($1,200 x 20%) so they take $240 out of your check for taxes
- Your final pay check is $960
Pay – Taxes = Take Home Paycheck
How Your Paycheck Works WITH Traditional Retirment Contributions:
- Your pay check is $1,200
- You contribute $120 into your traditional retirement account
- Your new taxable paycheck is $1,080
- THEN
- Your employer takes 20% out for taxes,($1,080 x 20%) so they take $216 out of your check for taxes
- Your final pay check is $864
Pay – Contributions = New Pay
THEN
New Pay – Taxes = Take Home Paycheck
So you have $120 saved and growing in your retirement account and your paycheck only went down $96! And you paid less in taxes!
That’s the power of pre-tax contributions!
How Traditional Retirement funds work tax-wise?
Traditional retirement accounts are filled up with pre-tax contributions (deposits). Throughout your working years, the government lets those accounts grow tax-free until you take them out.
When you take distributions (withdrawals) out of your traditional retirement accounts in retirement, it will be taxed as income in whatever tax bracket you are in for that year.
So, if you’re currently in a high tax bracket now, making Traditional Retirement Account Contributions can lower your tax bracket this year, and so long you’re not making the same amount or more in retirement, it saves you lots in taxes.
Example:
During your working years:
- Lets say you made $85,000 a year and fell in the 22% tax bracket
- You would deposit a portion of your check to your traditional retirement account and not pay a single dollar of tax on that contribution money now, so that it can grow until retirement
During your retirement years:
- You take $50,000 out of your retirement account each year for living expenses
- At $50,000 annual income, you now fall in the 12% tax bracket, instead of the 22% you were in during your working years
- You still have to pay income taxes but you never have to pay that higher tax bracket on that money and the difference gets to just grow
Traditional retirement accounts are best for people who:
- Make too much to contribute to a Roth account
- Want to be smart and save for retirement but need every possible dollar to live now
- Are currently in a much higher tax bracket now than they plan to be in during retirement
Roth Retirement Accounts
In 1997, the US government decided they were tired of people putting all their pre-tax dollars into Traditional Retirement accounts and waiting until retirement to pay taxes.
The government likes to get money now. They’re not big on planning ahead for the future.
So, they decided to create a retirement account that lets you put after-tax dollars in, allowing the government to get their tax dollars now and giving you tax-free money in retirement.
Thus, the Roth IRA (Individual Retirement Account) was created for people to start saving after-tax dollars on their own, outside of employer plans.
In 2006, Roth 401ks began in employer-sponsored plans too. So this is a rather new retirement savings option.
But, because Roth IRAs are such a sweet deal, the government put income limits on them. In 2021, the limit is a Modified Adjusted Income of $140,000 for singles or $208,000 for married couples filing jointly.
Employer-sponsored Roth 401k accounts do not currently have income limits, so if you are in a high tax bracket, you are welcome to pay all your taxes now and have tax-free dollars in retirement.
More Advanced Sidebar: If you make more than the Roth IRA Income Limit, there are sneaky (totally legal) backdoor Roth maneuvers.
People initially put money into a traditional account then move it to a Roth later on and pay taxes on it so it can grow tax-free. But as I write this, congress is trying to close that backdoor. So we’ll have to see if that backdoor is still viable in a few years. (The FI Tax Guy did a great end of 2021 tax planning Backdoor Roth article here)
How is a Roth Different from a Traditional Retirement Account?
With a Traditional Retirement Account, your retirement contribution is taken out of your paycheck before any taxes are pulled out. With a Roth Retirement Account, taxes are taken out first. A Roth is funded with after-tax dollars.
So while you don’t get any tax savings now, you will have access to tax-free money in your retirement.
No matter how much your retirement account grows from the time you put the money in between your working years and when you take it out, you will not pay a single dollar in taxes in retirement.
Example:
If Sam earns $40,000 a year now and is in the 12% tax bracket
- Sam will pay $4,601 in taxes this year (2021)
- If Sam contributes $300 a month to their Roth account with an average 9% return over 30 years, Sam will have put away just $108,000 but earned $402,633 in interest! I love this calculator.
- Because the growth is in an after-tax Roth account, Sam will not owe any taxes on those $402,633!!! That’s tax free money in retirement!
Roth Retirement Accounts are best for people who:
- Are currently in low tax brackets (as income goes up, you may be in higher tax brackets so take advantage of those low rates now and lock them in)
- Just want access to tax free money in their retirement years
- Need access to their money before 59 1/2 but still want to save for retirement
When Can You Take Money Out?
So both types of Retirement accounts, Traditional and Roth, were created with tax benefits, to encourage people to save for their retirement years. The government does not want you taking money out for any ol’ thing.
There is a rule that you can not access your traditional retirement funds until your reach 59 1/2 years old.
If you take monies out before 59 1/2, you not only have to pay taxes on it like regular income, but you also incur an extra 10% fine.
With these restrictions, many people become scared to put their money away in retirement funds, in case they might need it for an emergency.
When You Can Withdraw Early From a Traditional Retirement Account
There are a few exceptions that allow you to access your money early from traditional retirement funds without incurring the 10% penalty (but you will still have to pay income taxes):
- Medical expenses that that are not covered by insurance and exceed 7.5% of your adjusted gross income
- To pay for health insurance if you become unemployed for 12 consecutive weeks
- College Costs
- First time home purchase ($10,000 for individual or $20,000 for a couple)
- Birth or Adoption of a child (up to $5,000 per child)
- Severe physical or mental disability
- Withdrawal while on active military duty for more than 179 days
- To Set up an annuity
- To transfer money from a traditional retirement fund to a Roth Fund
- Rule of 55- if you leave your job at age 55 or older (50 for some public service jobs) and leave your money in a traditional 401k, instead of transferring it to and IRA, you can withdraw between the ages of 55 – 59 1/2.
Some companies will allow employees to take out loans, up to a certain percentage of their account. These are often low-interest loans, so you can access your money for whatever you need it for.
The interest you pay on the loan is just paying yourself back for all the growth interest you lose by not having that money in the market.
But, if you leave your job before the loan is paid back, you will have to pay the whole amount back immediately Otherwise, it will be counted as an early distribution and you’ll be charged the 10% penalty and have to pay income taxes on it that year.
This is also true if you default on the loan. So keep that in mind if you choose to do that.
When You Can Withdraw Early From a Roth Retirement Account
The awesome part of a Roth IRA is that the money you put into the account has already been taxed. It’s your money, free and clear to take out and do what you need with it, whenever.
BUT only the money you contributed is tax-free now, not the growth that that money has earned. Your growth is tied to the account until your turn 59 1/2 just like a traditional account before it becomes tax and penalty-free.
So you can use your Roth contributions for college savings, early retirement funds, or however you need.
Just make sure you follow the 5-year rule. Any money needs to sit in a Roth for 5 or more years before you can take it out.
So plan ahead and use your Roth as intended, to put money in and let it grow and compound.
Wrap -Up
I know, Traditional vs Roth Accounts is a super dry topic, but I hope this helps clear some things up and you put away those retirement dollars and build your wealth.
And please understand, it is great to have a mix of pre and post-tax accounts to take money out in retirement to create different tax benefits in retirement.
We personally have:
- A traditional 401k for Mr. Bean at work
- A traditional IRA that I transferred all my old 401ks into when I stopped working at those businesses
- And Roth IRAs in each of our names
An awesome reminder, a non-working spouse can contribute to an IRA too, so long the working spouse makes enough to fund both accounts.
So if you’re married, take advantage of all the tax savings you can, even if only one spouse is working full time.
Difference Between Traditional vs Roth Retirement Accounts
Traditional Retirment Accounts
- Pre-Tax Contributions
- Taxed as Regular Income in your retirement years
- Limited access before 59 1/2, or you will pay income taxes and a 10% Penalty
Roth Retirement Accounts
- After-Tax Contributions
- Tax Free in retirement years
- Contributions can be taken out at any age, after a 5 year “seasoning”
- Growth can not be accessed until 59 1/2 or you will pay income taxes and a 10% Penalty
HR told us we have access to Roth 401ks at work now too. I was wondering what the difference was.