Roth vs Traditional IRA vs 401(k) | 9 Things to Know Before Choosing a Roth IRA vs a Traditional IRA

2017 Guide: Roth vs Traditional IRA vs 401(k) | 9 Things to Know Before Making Your Decision

There are many retirement account options available to Americans, but figuring out which retirement account to open and contribute to can be difficult.

There are a lot of questions: should I opt for this or that? An IRA vs Roth IRA? And what variables am I even taking into consideration if I make a comparison between a Roth vs traditional IRA?

The first thing to say is that if you are even considering these questions, you are a step ahead. Do you know how much the average American couple has saved for retirement?

The average couple has just $5,000 saved for retirement.

That’s an unacceptable and scary amount to have to rely on in old age. Deciding to get serious about comparing Roth IRA vs IRA is a step further than most people have gone.

Individual retirement accounts, or IRAs, are the most popularly known retirement accounts next to the 401(k), but then there is the question of the difference between an IRA vs Roth IRA.

This article will compare the Roth vs traditional IRA and go over the differences between taxes and contribution limits when making your choice.

1. Either IRA Is Better Than Putting Your Money in a Savings Account

In a Roth vs traditional IRA match-up, either choice is better than a savings account. A savings account can be great for short-term savings.

It is separated from your checking account, which creates separation from your day-to-day banking, but it still allows for flexibility if you need to withdraw from your account. But when it comes to long-term savings for retirement, a savings account is not where you want to put your money.

If you get tired of making Roth vs traditional IRA comparisons and decide that parking all of your money in a savings account is best, you are shooting yourself in the foot. Savings accounts offer very little in the way of interest.

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They will not pay you very much for letting the bank borrow your money (which they subsequently loan out to other customers for a substantially higher interest rate).

This means that your money will not be earning much. Still willing to buck that Roth vs traditional IRA comparison? That’s not a very smart strategy. You may be okay with not earning extra money, but are you okay with the prospect of losing money?

Your money loses its purchasing power the longer it is in a savings account. In an IRA vs Roth IRA vs savings account comparison, the savings account is the clear loser. The interest earned simply cannot keep up with the rate of inflation, meaning the purchasing power of the money you have saved away will become smaller and smaller the longer it is in a savings account.

As the price of products and services become more and more expensive, the money you have saved will be worth much less. For this reason, putting your money in savings puts you in a vulnerable position. You may reach retirement only to find that the cash you diligently put away is not enough to live comfortably in old age. So before you dash away that IRA vs Roth IRA list, think a little bit about the effects of keeping your retirement savings in a regular account.

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2. IRA vs Roth IRA: Diversify Your Investments

Whether you are considering a Roth IRA vs traditional IRA, you will benefit from an account with tax-advantaged status. To make the most of this tax advantage, diversify the investments within your account.

There are different rules for a Roth IRA vs traditional IRA, but for either type of individual retirement account, there are a wide range of investments you can choose. This means that you can benefit with the growth of stocks, bonds, mutual funds, and more while enjoying the tax-deferred status.

Traditional vs Roth IRA: How do capital gains work within a traditional IRA?

When you make contributions toward a traditional IRA, the tax advantage happens at the time of contribution. Your traditional IRA contributions are tax deductible. You pay income tax at the time of withdrawal (ideally during retirement).

In the meantime, any growth in your investments do not face a capital gains tax. But there are slight differences in terms of the tax advantages when you make a traditional vs Roth IRA comparison.

Traditional vs Roth IRA: How do capital gains work within a traditional IRA?

With a Roth IRA, your contributions are not tax deductible. This means that you do not realize any tax advantages at the time when you are contributing money to it. This is the main difference between the traditional IRA vs Roth IRA.

But this does not mean that between the traditional IRA vs Roth IRA only the traditional IRA has the attractive tax savings. They both do; the key difference is when you realize the tax savings.

With a Roth IRA vs traditional individual retirement account, you get the tax benefits and advantages at the time of withdrawal. When it comes to the timing of tax advantages, there are a number of factors to consider when choosing between a traditional IRA vs Roth IRA (which we will discuss later in this article).

At the time of withdrawal, you are not required to pay any taxes on your IRA distribution.

So in a Roth IRA vs IRA, you can enjoy the capital gains and use the income in retirement without worrying about paying the IRS, since that was already done when you paid your income taxes during the year of your contribution.

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3. Whether You Choose a Roth IRA vs Traditional IRA, Start Early!

If you are torn between a Roth IRA vs IRA, hopefully you are conducting this comparison sooner rather than later — because saving for retirement is something best done earlier.

Most financial advisors recommend starting to save for retirement in your twenties. The first reason is the most obvious one: compound interest works in your favor if you are compounding that money over a longer period of time.

The other reason is that you can benefit from the volatility of the market (and the potentially higher earnings that come with it) if you are investing over a longer period of time.

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Investing in the stock market can be a stressful activity. It can also be a lesson in irrationality. Investors typically behave in ways that are contrary to their best interests: they buy when stocks are pricey (when the market is doing well), and sell when the stocks are cheap (when something is going wrong).

Typically, this occurs when people are panicked about losing their money. For either account (a Roth IRA vs traditional IRA) there is some built-in incentive to ride things out.

Our popular culture is obsessed with the idea of making big money in the stock market, but oftentimes the investors who make the best investments are the investors who practice patience. A long-term strategy is oftentimes the best strategy for investing in the stock market, and whether you choose a Roth IRA vs traditional IRA, both accounts are designed for long-term savings and a long-term mindset.

Additionally, you can take riskier bets with your investments if you start early. In your twenties and thirties, you can put a larger amount of your retirement savings in stocks to realize growth with the comfort of knowing you have time to make up for any serious losses.

Then, as you get older and closer to actually needing the money, you can start to move that increased amount of money to safer, fixed investments like bonds or certificates of deposit (CDs). This strategy can be applied whether you want a Roth IRA or traditional individual retirement account.

4. A Traditional IRA vs Roth IRA Is Better If You Make Less in Retirement

With both the traditional IRA vs Roth individual retirement accounts, you are experiencing tax advantages, but which tax advantage is better for you?

If you choose the traditional IRA, you enjoy the tax savings immediately. But if you choose the Roth IRA, then you enjoy the tax savings at the time of your withdrawals. So when comparing the tax advantages of an IRA vs Roth account, which one will work to your advantage the most?

If you are thinking about the tax savings when you are comparing an IRA vs Roth account, an individual retirement account is best if you think you will be making less money in retirement that you are now. If you will be making less in retirement than you are at the time of your contributions, you will be paying a lower marginal tax rate.

And you will not be paying taxes on everything in your IRA at the same time — just your withdrawals.

So if you have planned your withdrawals so that the amount you get each year is less than your current income, you will be paying less money toward the IRS each year while in retirement. This is definitely something to consider when comparing the IRA vs Roth.

5. A Roth IRA vs Traditional IRA Is Better if You Will Be Making More in Retirement

On the flip side, if you will be making more money in retirement (and tax considerations are the biggest factor when comparing a simple IRA vs Roth IRA), then a Roth IRA is your best choice.

With a Roth IRA, your contributions are not tax deductible. But when you eventually withdraw your money in retirement, they will not be taxed, meaning you can enjoy your earnings without worrying about cutting off a specific percentage each month.

If you know your retirement income will be higher than your current earnings, then you will likely be paying a higher marginal tax rate. In that case, between the simple IRA vs Roth IRA, opting for the Roth IRA may be your better option.

6. Whether It’s a Simple IRA vs Roth IRA, Contributions Are Limited Per Year

It does not matter if you choose a Roth vs traditional IRA or IRA vs Roth IRA; both accounts have annual contribution limits.

IRA vs Roth IRA: Contribution Limit for Traditional IRA

If you decide to open an IRA, you can only contribute a certain amount of money each year. Naturally, this is to prevent people from making an astronomical amount of investments in a tax-protected account.

With an IRA vs Roth IRA, you can contribute $5,500 per year (if you are under the age of 50) and $6,500 per year if you are 50 years of age or older.

Roth vs Traditional IRA: Contribution Limit for Roth IRA

With a Roth IRA, the contribution limit is the same as the traditional IRA, but there is a sliding scale that is based on income. Additionally, this sliding scale is based on your marital status. The presence of a sliding scale for contribution limits is another key difference between the IRA vs Roth IRA.

If you are single, you must be making less than $117,000 in order to contribute $5,500. For those who make between $117,000 to $131,999, there is a sliding scale for the contribution limits.

If you are married, you must be making less than $184,000 in order to contribute $5,500. Between $183,000 and $193,999, there is a sliding scale for the contribution limits.

7. Roth IRA Eligibility is Determined Using Your Modified Adjusted Gross Income (MAGI)

The limits used to determine whether you are eligible for a Roth IRA is determined using your Modified Adjusted Gross Income, also known as MAGI. (There is no income requirement limit for a traditional IRA vs Roth IRA, so long as your income is earned income.)

You simply take your adjusted gross income and add your deductions. In most cases, these numbers are extremely close, but they could have bearing on particular situations (like the details of your Roth IRA contribution), so it is an important number to understand or at least be familiar with.

8. Understand the Difference Between Traditional IRA vs 401(k) and Roth vs Traditional 401(k)

The key difference between a traditional IRA vs 401(k) or a Roth vs traditional 401(k) is that individual retirement accounts can be opened by individuals while 401(k) accounts cannot be. Individuals participate in a 401(k) through their place of employment.

With a traditional IRA vs 401(k) or a Roth vs traditional 401(k) account, the IRA limits are set by the Internal Revenue Service, whereas the limit for a 401(k) account is set by the employer.

If an employee opts into their employer’s 401(k) program, a pre-tax amount is deducted from their paycheck and contributed to the program. Employees can choose what kind of funds their contribution goes toward, with different funds carrying different risk tolerances.

Some employers offer matching contributions on 401(k) accounts, which can make a 401(k) account more attractive for some people saving for retirement.

9. With a Traditional IRA, You Are Required to Start Making Withdrawals by a Certain Age

Another important point to make when comparing Roth IRA vs traditional IRA is that with a traditional IRA, you are required to start making withdrawals at some point. There is a minimum distribution amount that begins at 70 and a half years old.

There is no minimum distribution amount for Roth IRAs.

Conclusion: Roth vs Traditional IRA vs 401(k)

If you are set on getting an individual retirement account, consider some of the tips and information above to make the best decision for your retirement planning. And remember: there’s no better time to get started than right now.

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