IRA Comparison: Understanding the Distinctions Between Roth and Traditional
IRA Comparison: Understanding the Distinctions Between Roth and Traditional
Traditional and Roth 401(k) retirement plans share similarities as they both offer tax advantages. The primary distinction between a Roth 401(k) and a traditional 401(k) lies in the timing of the tax benefits they provide. Traditional 401(k)s offer tax relief upon contribution, while Roth 401(k)s delay this tax benefit until retirement.
There are other substantial differences between the two, including eligibility rules, penalties for early withdrawal, and mandatory distributions in the future.
Roth 401(k) vs. traditional 401(k): Tax breaks
Roth 401(k) vs. traditional 401(k): Tax breaks
Contributions to traditional 401(k)s reduce your taxable income in the year you make the contributions, thereby lowering your tax burden by the respective tax bracket. For instance, if you contribute $1,000 to a traditional 401(k) in 2025, and your tax rate is 22%, your subsequent tax bill could decrease by $220.
On the other hand, Roth 401(k) contributions do not provide any immediate tax benefits. A $1,000 contribution to a Roth 401(k) in 2025 will not impact your taxable income or reduce your tax bill in the same year.
However, Roth 401(k)s allow for tax-exempt withdrawals as long as you adhere to the withdrawal guidelines. Should you extract $1,000 from your Roth 401(k) during retirement, you will not owe taxes on the withdrawn amount.
In contrast, you'll pay taxes at your ordinary income tax rate once you withdraw money from a traditional 401(k) during retirement. Consequently, your taxable income will increase by $1,000, and you will be taxed on this amount based on your current tax rate.
If you anticipate being taxed at a higher rate in retirement compared to now, you should contemplate contributing to a Roth 401(k). Conversely, if you anticipate a lower tax rate in retirement, a traditional 401(k) might be a more suitable option. It's always advantageous to pay taxes when your tax rate is lower.
Eligibility requirements differ
Eligibility requirements differ
Participation in a Roth 401(k) is restricted by income limits. Although backdoor Roth 401(k) contributions are permitted to bypass these limits, participants cannot contribute directly to a Roth 401(k) if their earnings surpass these thresholds.
Conversely, traditional 401(k)s are more flexible in this regard. Individuals with no workplace retirement plans and/or partners without workplace retirement plans can make tax-deductible contributions to traditional 401(k)s regardless of their income level.
Should either you or your partner have a workplace retirement plan, your eligibility to deduct contributions from a traditional 401(k) is contingent on your income level. However, you can still contribute non-deductible funds and benefit from tax-deferred growth, although you won't be able to claim a deduction for the year's contribution.
Withdrawal rules vary
Withdrawal rules vary
Early withdrawals from traditional 401(k)s before age 59 1/2 are subject to a 10% penalty, irrespective of whether the withdrawn funds represent contributions or gains.
In contrast, Roth 401(k) withdrawal rules are less stringent. You can withdraw your contributions without incurring penalties at any time, although gains, if withdrawn prior to age 59 1/2, are subject to a 10% penalty.
Once you reach age 59 1/2, you are free to withdraw money from your traditional 401(k) without consequences. Roth 401(k)s, however, have an additional rule to consider: the five-year rule. This rule entails waiting at least five years from the tax year of your initial Roth 401(k) contribution to make tax-free withdrawals.
Moreover, there's an additional requirement for traditional 401(k)s. Once you turn 72 (previously 70 1/2), you're required to take mandatory annual distributions, known as required minimum distributions (RMDs). Failure to withdraw the minimum amount could result in a 25% penalty on the unwithdrawn amount. However, if you take prompt action, this penalty may be reduced to 10%. Roth 401(k)s, fortunately, are not subject to RMDs.
Which is the better choice: Roth 401(k) or traditional 401(k)?
Which is the better choice: Roth 401(k) or traditional 401(k)?
A Roth 401(k) is beneficial if:
- You foresee being in a higher tax bracket during retirement and wish to delay your tax savings.
- You wish to avert government-mandated required minimum distributions (RMDs).
- You desire the ability to withdraw contributions without penalties at any time.
A traditional 401(k) is preferable if:
- You envision being in a lower tax bracket during retirement, thereby favoring the immediate tax relief.
- Your income level surpasses the limit for contributing to a Roth 401(k).
- You qualify for tax-deductible contributions due to a lack of a workplace retirement plan.
It is worth noting that there might be additional factors that influence your decision, such as your retirement goals, economic projections, and personal financial situation. It's advisable to consult a financial advisor to determine the best course of action for your particular situation.
In 2024, you can allocate $7,000, or $8,000 if aged 50 and above, eligible for additional contributions. The 2025 allocations remain the same. You can invest this whole sum in a Roth or a conventional IRA, or partition it as per your preference between these accounts. However, the total contribution limit for both accounts determines the overall sum you can invest. You cannot invest $7,000 in a conventional IRA and another $7,000 in a Roth IRA.
Got a Roth or a conventional IRA?
Both Roth and conventional IRAs are personal retirement accounts, which means you open them independently with a financial institution, such as a bank or brokerage firm. Many financial institutions offer both types of accounts, so when you apply for one, just choose your preferred option.
If you have an existing IRA but unsure of its type, contact the broker or bank where you opened the account. The account title might specify its type, or you can reach out to customer service for clarification.
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In this context, here are two sentences that contain the words 'retirement', 'finance', and 'money': During retirement, tax-exempt withdrawals can be made from a Roth 401(k) if you adhere to the withdrawal guidelines, saving you money in taxes. If you anticipate being taxed at a higher rate in retirement compared to now, it might be financially wise to consider contributing to a Roth 401(k).