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Roth vs. Traditional Retirement Accounts

Roth accounts are a fairly new phenomenon and were introduced in the Taxpayer Relief Act of 1997. I like to think of them as the mirror image of the traditional retirement accounts.  

To start, a Roth IRA and a Traditional IRA have similarities. They both allow money to grow tax deferred inside the accounts so any growth, dividends or income (earnings) inside the accounts are not taxed while they remain in the accounts. The annual contribution limits are the same at $6,000 for those under age 50 and $7,000 for those age 50 and over. Contributions for the previous year can be done up until the tax filing deadline of the following year, usually April 15.  They both can hold various types of investments, including stocks, bonds, mutual funds and ETFs as the most common.

The main difference between a Traditional IRA and Roth IRA is in the taxation of contributions and distributions.  

The original IRA and 401k accounts allowed for pretax contributions, which means the tax benefit was upfront and you could reduce your income by the amount of contribution. The taxes come when retirees begin to take distributions, usually after 59 ½, and are fully taxable as income. In general, if money is taken out before age 59 ½ a 10% penalty applies along with income taxes. Investors are eligible to contribute to an IRA if they don’t have a retirement plan through work. If you do have a retirement plan or your spouse does, you are only able to contribute to a Traditional IRA if your adjusted gross income is under a certain amount, which changes annually.  

A Roth IRA does not have a tax benefit when contributing and the tax benefit begins when the retiree pulls from the account. All qualified distributions from a Roth are tax free. Another benefit of the Roth is the ability to pull contributions at any time without penalty. The 59 ½ rule applies to earnings inside the Roth but an additional five-year rule exists for a Roth IRA. A participant must wait five years after their first contribution to a Roth to withdraw earnings tax-free. This rule supersedes the 59 ½ rule, meaning if you make your first contribution to a Roth for 2022 and are 58, you can’t pull earnings from the Roth without penalty until January 2027. It is a generous rule, in that if you made the 2022 contribution in 2023 before April 15, you still can withdraw earnings without penalty starting Jan. 1, 2027.

All things being equal, a Traditional IRA is better when a person is making the most earned income and there is less time until retirement. A Roth is better when a person is in a low tax bracket and has longer until retirement. A younger person who just started to work is a perfect example of a prime candidate for a Roth. The tax benefit of the Roth comes from the growth and income inside the account, which is never taxed. This means that the longer you leave money inside the account to grow, the more the tax benefit is worth. Putting the high growth investments inside the Roth can also make sense since maximizing the returns in a Roth gives the most tax benefit.

Traditional IRA and Roth IRA have many other intricacies, including, but not limited to, exceptions to the 59 ½ rule for certain expenses, Roth IRA conversions and rolling money from an employer retirement account into an individual retirement account. Before deciding on converting or contributing, speak to a qualified professional who can discuss the plus and minus of the different choices and what would be best in your situation.

All investing is subject to risk, including possible loss of the money you invest. Nothing in this article should be construed as investment or retirement advice.  Always consult with a professional advisor and consider your risk tolerance and time to invest when making investment decisions. Review your personal situation with a professional before planning any gifting or estate planning.

Judy Loy is a Registered Investment Advisor, ChFC®, RICP® and CEO of Nestlerode & Loy, Inc. in State College.