Is a Traditional or Roth Retirement Account Better?

People disagree about whether Traditional or Roth retirement accounts are better. Compelling arguments can be made both ways, leaving the topic as clear as mud to many people. The truth is there’s no simple answer. What’s best depends on the specific needs, goals, and circumstances involved. We started looking at this topic in a previous post about Roth IRAs. We’ll explore the Roth vs Traditional topic further in this article.

Overview of Roth vs Traditional

To start, what do the terms Roth and Traditional mean? Both terms refer to the tax treatment of retirement accounts, like IRA or 401(k) accounts. When people contribute to their retirement accounts, they may receive tax benefits. Those benefits differ depending on whether the account is Roth or Traditional. Since retirement accounts typically have annual contribution limits, people often must choose how to allocate between Roth and Traditional options.

Traditional retirement accounts

Traditional retirement accounts (TRAs) provide upfront tax benefits. Someone who makes a TRA contribution in Year 1 could also receive a tax deduction for Year 1. For example, one could receive a $300 tax deduction for making a $1,000 TRA contribution (assuming a 30% tax rate). The upfront tax benefit makes TRAs a popular choice for people who want current tax breaks.

In addition to the upfront tax deduction, TRAs also provide tax deferrals. Gains and income earned on monies inside of TRAs are not taxed until the funds are withdrawn, normallly in retirement. When funds are withdrawn, they are subject to income tax.

Withdrawals deemed to be non-qualified distributions (NQD) are subject to a 10% penalty (in addition to income taxes). A common example of an NQD is withdrawing money too early, or a “premature distribution” (prior to retirement age 59.5) without a valid exemption.

TRAs do not eliminate taxes, rather taxes are delayed until retirement. Even so, tax deferrals can have considerable value on their own.

Roth retirement accounts

Roth retirement accounts (RRAs) provide future tax benefits. If you make an RRA contribution in Year 1, there is no tax deduction for Year 1. That makes the RRA contribution more costly upfront than the TRA example above. For instance, if we want to make a $1,000 RRA contribution, we would still need to pay another $429 in income tax for a total outlay of $1,429 (assuming 30% tax, $1,000 is 70% of $1,429).

Just like in a TRA, money will grow without taxes as long as it stays inside an RRA. However, qualified withdrawals from an RRA are not subject to income tax. In other words, the income and gains earned inside the RRA can potentially become tax-free. There are conditions for tax-free treatment such as the need to hold the RRA for at least five years.

The potential tax-free treatment of RRAs is a rare and valuable benefit.

Which is better?

Advocates of RRAs may insist on plowing as much retirement savings into them as possible. After all, RRAs are one of the very few ways to get tax-free treatment in the US.

Proponents of TRAs prefer upfront tax benefits today instead of potential tax benefits in the future. TRA tax deductions are valuable and don’t carry over from year to year. So it’s either use them or lose them.

Both sides have compelling arguments, but what’s best depends on personal needs, goals, and circumstances.

One important consideration is income level. First, there are income limits for who can contribute to Roth IRA accounts. As of 2022, single tax filers with modified-adjusted-gross-income (MAGI) above $140,000 are ineligible for Roth IRA contributions ($214,000 for married tax filers). Keep in mind this only applies to Roth IRAs, Roth 401(k) accounts typically do not have income limits. Also, there are still loopholes that allow high-income earners to fund “backdoor” Roth IRAs.

Meanwhile, Traditional IRA accounts have income limits for deductible contributions. If you or a spouse have access to an employer-sponsored retirement plan (like a 401k plan), you may be ineligible for deductible TIRA contributions with MAGI over $125,000 (joint) or $76,000 (single) as of 2022.

Keep in mind those income limits typically do not apply to Traditional 401(k) accounts, or if you do not have access to an employer plan. Also, the limits are for deductible TIRA contributions, non-deductible TIRA contributions may still be allowed.

Even when income limits do not apply, people should consider how income may change over time. For example, people who are in their peak earning years may value a current TRA tax deduction more than a future RRA tax exemption. This is especially true if income is expected to decrease substantially in retirement. The reverse may hold for someone with low current earnings.

Another variable is the tax code. If tax rates are higher during retirement than before retirement, then the future tax-free benefit of the RRAs increases, all else equal. The reverse is also true. Of course, no one can predict tax rates, and all else is often not equal. For example, higher tax rates could be offset by lower income.

Then there are other moving parts to consider. Those who have maxed out their Traditional 401(k) contribution limits for the year, may not receive additional tax deductions for contributing to a Traditional IRA. In that case, it could make sense to capture the future benefits of RRAs with a Roth IRA contribution instead (assuming income permits).  In some cases, it may even make sense to consider converting a TRA into an RRA.

There are also other considerations like the need to pull funds prematurely, the ability to “convert” IRAs, and advanced issues like estate planning. If the objective is to leave the money to heirs, RRAs do not have “required minimum distributions” (RMDs), while TRAs do at age 72. The lack of RRA RMD helps preserve tax benefits and can maximize the value of a bequest.  Also, the tax treatment of RRAs and TRAs may be different for heirs.

There are too many considerations and caveats to list, but the best source of information is the IRS website’s retirement plan page. It provides detailed information on all the topics discussed in this article and more.

The bottom line

There is not a clear answer to whether a Traditional or Roth retirement account is better. The answer is that the best choice is the one that meets the individual needs, goals, and circumstances at play.

Keep in mind that this article does not represent personal tax or financial advice. It is for informational purposes only, and hopefully, it leaves the TRA vs RRA debate less muddy than you found it.

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HWL