Traditional And Roth Accounts: What's The Difference
Should you be using traditional or Roth retirement accounts? Do you know the difference? If not, don't worry; many people don't and even those who do may not be using them correctly.
Retirement Account Types
We have access to different types of accounts to help us save for different goals, such as health care costs (Health Savings accounts) or education (529 plans). Another type of account is a retirement account. We are able to put money away for our retirements and tax incentives exist to get us to do so.
Even though that sounds quite easy, there are so many choices of retirement accounts. There are 401(k) plans, 403(b) plans, individual retirement accounts (IRAs), 457(b) plans, Roth IRAs, Roth 401(k) plans, Roth 403(b) plans, Roth 457(b) plans and more (believe it or not). How are we supposed to know what to do?
All these accounts are very similar in tax treatment. The main difference is between those that are labeled as "Roth" accounts and those that are not. Those that are not called Roth accounts I will be calling traditional accounts for our purposes.
Traditional
Traditional retirement accounts work like this. You get a tax break on the money that you deposit into the account. Then your money gets to grow tax deferred, meaning you don't pay any taxes on the gains (dividends, interest, capital gains) while the money is in the account. You only pay taxes when you withdraw your money.
Roth
Roth retirement accounts, on the other hand, do not get a tax break up front. You deposit your money after you have already paid income tax. Your reward for not getting a current tax break is that your money gets to grow tax free, AND you do not pay any taxes on the money when you take it out.
All Else Equal
So with a traditional account you pay no taxes until you need the money and with Roth accounts you pay tax now and then never again.
One common misunderstanding people have is that if you remain in the same tax bracket and tax rates do not change, then both of these will result in the same exact outcome. The reason why is a little technical and mathy, but concise it to say, if nothing changed it wouldn't matter.
But alas, things do change. Your income levels change. The tax rates change.
When To Use Each
Since these accounts are a pay-tax-now-or-pay-tax-later situation, then the answer of when to use either of these come down to whether you think you will have to pay more taxes now or in the future. Pay the tax when it is cheapest to do so.
If you are in a low tax bracket now and think you will be in a higher tax bracket when you need to withdraw your retirement money, then pay the tax when it's cheap - which is now. You would want to use the Roth accounts (with no tax break now but never having to pay tax in the future).
If you are in a high tax bracket now and think you'll be in a lower tax bracket in when you need the money, then pay the tax when it's cheap and delay it until the future. You would use the traditional accounts so you can get the tax break now.
Even if you don't think you'll be in a different relative tax bracket (e.g. highest tax bracket, lowest tax bracket), you can still try to determine which one makes sense if you think overall rates will change (like they did for 2018). If you think overall rates will be higher in the future then you would want to pay taxes now and use the Roth accounts. If you think rates will go down in the future, then you would want to put off paying taxes and use the traditional accounts.
Other Considerations
There are some nuances to be aware of, especially with regard to the Roth IRAs.
With a Roth, since you have already paid taxes on the money you deposit, the government really doesn't care about it anymore. What that means is that you can access the amount you've deposited, even before you retire, without paying taxes or penalties.
You can use Roth IRA dollars to purchase a first home or to pay for college expenses without paying penalties. You still have to pay tax on the gains (but not your original deposits), but at least you are not penalized.
There is a five-year rule with Roth IRAs, though, meaning you have to have the account open for five years before some of these cool features kick in - even before withdrawing gains after retirement. So if a Roth IRA is going to be part of your financial plan, then open one as soon as possible to start the clock. It doesn't matter how much is in it, just when it was opened.
The Roth IRA also has income limits, so if you're income is too high then you will not qualify for the Roth IRA. You can still use the Roth 401(k) (or other employer sponsored plan), but the IRA would not be an option. But keep in mind, if you're income is too high then it is possible you would want to use traditional retirement accounts anyway. Traditional IRAs also have income limits on the tax deductible deposits.
One-Size-Fits-All Does Not Apply
There is no such thing as "everyone needs to..." It doesn't exist in the personal finance world. Understanding how these similar yet very different account types work, and taking a close look at your current and perceived future situations will get you well on your way to good money health.
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