Coke vs Pepsi, Mayonnaise vs Miracle Whip, Twizzlers vs Red Vines – some conversations will go on until the end of time (though the first item listed in each pair is clearly the superior option). A major investment discussion is undoubtedly tax-free vs tax deferred retirement accounts. Though both are examples of tax-advantaged accounts, tax-free (Roth) and tax-deferred (Traditional) accounts are very different. In fact, if you have some extra money to invest, you also have a third option, a taxable account. In this article we help you navigate which accounts are best for you – a tax-free account (like a Roth IRA or Roth 401(k)), a tax-deferred account (like a Traditional IRA or Traditional 401(k)), or a taxable account.
First of all, why are there so many accounts? Why couldn’t there just be one account? If there were only one account type, it would undoubtedly be the taxable account (so the government could get paid anytime you made money investing). The abundance of account types is actually a good thing. The government created these other account types to try to encourage saving for retirement – these extra account types exist to help you save and invest in a tax-advantaged way.
Can I put any type of investment in any type of account? Yes you can, but generally speaking you won’t be able to put all of your investments in tax-advantaged accounts (though you would want to, but unfortunately there are annual contribution limits), so you will have to split your investments between taxable and tax-advantaged accounts. One perk of tax-advantaged accounts is that investments grow tax free (and rebalancing investments, which could cause a capital gain in a taxable account is tax-free, as are dividends and interest).
How are Roth and Traditional IRA’s different? Contributions to Roth IRAs are with after-tax dollars (dollars in your bank account, for example), that then grow tax-free inside the Roth, and when you take the money out (after 59 ½ years old), you don’t pay any taxes. Typically, for Traditional IRAs you contribute with pre-tax dollars (dollars in your bank account are after-tax, so when you contribute to a Traditional IRA you can deduct those dollars from your taxes, effectively turning them back into pre-tax dollars), that then grow tax-deferred inside the Traditional IRA, and when you take the money out (after 59 ½ years old), you will pay ordinary income tax on everything taken out. This is the first major difference, for Roths you pay taxes upfront, for Traditionals you pay taxes later when you withdraw funds. If you think your tax rates are lower now than they could be in the future, a Roth may make more sense. If you think taxes will fall in the future, a Traditional may make more sense. Many people find Roth’s more appealing because they remove the unknown risk of future tax rates, and because some economists believe that the large US deficit will require future income taxes to be higher.
There are many calculators that help determine which could be better for you. If you start with $10k, and invest another $5k a year for 10 years (using assumptions below), you would end up with $78,954 in a taxable account, $80,054 from a Traditional (tax-deferred) account after withdrawal, and $86,739 in a Roth (tax-free) account. But we must remember that you can deduct the Traditional investment each year from your taxes, so this is a partial tax benefit in each of the prior 10 years for the Traditional:
There are some similarities between a Roth and Traditional. You cannot contribute more than you earned in a year for either Roth or Traditional. You cannot exceed IRS limits (for 2019, $6k if under 50, $7k if 50 or older). The deadline is April 15th of the following year to contribute (Maine and Massachusetts residents have until April 17th in 2019). You can withdraw funds after 59 ½ without penalty.
What are other benefits of a Roth? You can contribute to a Roth at any age (must be under 70 ½ for a Traditional). If you need money from your Roth before 59 ½, you can take out your original contribution amounts at no penalty (taking out earnings from a Roth early has a 10% penalty, and taking out anything from a Traditional early has a 10% penalty plus taxes). There are no required minimum distributions (RMDs) from Roth IRAs while you are alive. For Traditionals, RMDs start at age 70 ½.
Are there any other perks of a Traditional? There are income limits(Modified Adjusted Gross Income) to contribute to a Roth, that do not exist for a Traditional, (however you may be able to side-step these with a back-door Roth). You can deduct some or all of your contribution to a Traditional IRA (though there are limits you must meet to deduct). You can take earnings tax-free from a Roth after you are 59 ½ and the Roth is at least 5 years old (there is no minimum age for a Traditional).
If you have any questions about Roth or Traditional IRAs, please let us know. As always, keep calm and invest on.