All retirement accounts have some form of special tax treatment, however, they are not all created equal. As an individual we can contribute to a Traditional IRA or Roth IRA (subject to income limits) and often as an employee we can elect to make Traditional 401k or Roth 401k contributions as well. But what is the difference between a Traditional and a Roth?
The difference between the two
Let’s start with an Individual Retirement Account or “IRA” as they are commonly known. The primary difference between a Traditional IRA and a Roth IRA contribution is that Traditional IRA contributions may be eligible for a tax deduction in the year they are made which is a fancy way of saying the dollars are “pre-tax”. Roth IRA contributions, on the other hand, are not tax deductible in the year they are made and therefore are “post-tax” money.
Additionally, both accounts receive preferable tax treatment as they will grow tax free during your working years and you can postpone any tax liability on the growth into your retirement years. This is different from a standard investment account, also known as “taxable” investment account. In all investment accounts, retirement or otherwise, you typically will have investments that either (a) have dividends or income which pay you money or (b) you will sell an investment. When this happens there are tax consequences. For example, if your stock pays you a $1 per share dividend in 2020, you will owe income tax on that $1 per share. This is not true for these retirement accounts. Any gains or income incurred is tax free until you withdraw from the account.
What happens to these accounts when you hit retirement?
Fast forward to retirement (after age 59.5) when you could begin distributing money from your Traditional IRA. As you take funds from your Traditional account they are taxed at ordinary income tax rates. Conversely, withdrawals from a Roth IRA account are non-taxable during retirement (because you funded this with post-tax money). Therefore, when deciding which type of IRA to contribute to, you need to consider your current tax rate versus what your tax rate may be during your retirement years.
What are the limits to my contributions each year?
In 2020, the maximum contribution an individual can make to either a Traditional IRA or a Roth IRA is $6,000 if they are under the age of 50. If you are over the age of 50 they allow you to contribute $7000. These are the maximum contribution limits, however, how much you can contribute is limited by your earned income (you may not have earned income in a year you decide to go back to school, for example). If your earned income is less than the contribution limit, you can contribute an amount equal to your earned income. As of 2020, there is no maximum age at which you can contribute to an IRA as long as you earn income equal to how much you contribute.
While these accounts are great tools for retirement savings, there are some restrictions on who is eligible to contribute to these account types.
- Traditional IRAs: If you are covered by an employer sponsored retirement plan (think 401(k)) at work, or your spouse is covered by such a plan, you may not be eligible to make a full or even partially deductible contribution. Please reference the income limits as set by the IRS for deducting your Traditional IRA contribution.
- Roth IRAs: Income limits also restrict who is eligible to make a partial or full Roth IRA contribution. Please reference the income limits set forth by the IRS.
What about company retirement plans?
Now that you’re an expert on Traditional IRAs and Roth IRAs, let’s talk about the 401k. Contributions to a Traditional 401k also go into your plan pre-tax by your employer and/or employer plan. Unlike a Traditional IRA, however, income limits do not apply when determining the deductibility of the contribution. Most employers also offer the Roth 401k option, which was only recently introduced in 2006. Like the Roth IRA, contributions to the Roth 401k are made with post-tax money and there are no income limits to prevent people from making Roth 401k contributions. As with the Traditional IRA, Traditional 401k accounts are taxable upon distribution, and Roth 401k accounts are non-taxable upon distribution during retirement. Traditional and Roth 401k contributions are both eligible for an employer matching contribution, however the employer matching contribution will be taxed when withdrawn during retirement regardless of which type of 401k contribution you choose to make.
In 2020, the maximum contribution an individual can make to either a Traditional 401k or Roth 401k is $19,500 if they are under the age of 50, and up to $24,500 if they are over the age of 50. You can make any combination of Traditional 401k and Roth 401k contributions up to this annual limit. For example, if you contribute $10,000 to your traditional 401k you can contribute a maximum of $9,500 to your Roth 401k that year.
The first step in saving for your retirement is understanding what account types are available for you. Here are a few additional tips to consider.
Tip #1: By building up a balance of both Traditional retirement assets and Roth retirement assets, you will provide flexibility for yourself during retirement years. When you are pulling from your retirement portfolio to cover living expenses, you will have the option of pulling from assets that will be taxable upon distribution (Traditional or regular investment account) as well as assets that are non-taxable upon distribution (Roth). One could use a strategy of pulling from taxable assets to bring their income up to the top of a targeted tax bracket, then switching to assets from non-taxable accounts and therefore keeping the average income tax rate of all taxable distributions down over time.
There are a few other benefits to consider regarding Roth contributions:
- Roth IRAs are not subject to life-time annual required minimum distribution. For Traditional IRA’s you must start distributions by age 72, these distributions are taxed at ordinary income tax rates. (The government won’t let you escape taxes forever!)
- While Roth IRAs are subject to required minimum distributions after-death (in this case a non-spouse beneficiary is required to distribute their inherited Traditional IRA or Roth IRA within 10 years after the decedents’ passing unless they are eligible for special treatment*) such distributions are non-taxable to the beneficiary .
Tip #2: If you’ve maxed out your 401k contributions and still wish to save additional funds in tax-advantaged savings but you’re over the income limits for the Traditional IRA and Roth IRA contributions as mentioned above, click here to read about an alternative planning strategy: Non-deductible IRA contributions followed by Roth Conversions. We talk about these in greater detail here.
For all the visual learners reading along, I’ve included a table that summarizes this information:
Tip 3: Money put into a Roth IRA can be pulled out at any time for emergencies or to pay for college tax and penalty free. Note, that this is only the contributions that are allowed to be removed without penalty. Any growth on those contributions would be taxed and penalized. While we don’t ever recommend this because we want you to focus on saving for retirement, it’s important to note it's an option. In that event you would.
We recommend contacting your Origin Planner to discuss your specific situation and get personalized advice about what type of contribution would be the most tax-efficient for you.
*Eligible beneficiaries include a surviving spouse, a minor child of the deceased owner, disabled or chronically ill individual, or any other person who is not more than 10 years younger than the deceased account holder. Eligible designated beneficiaries have the option to take Required Minimum Distributions based on their life expectancy.