What Is the Difference Traditional VS. Roth? What Do I Choose?

Most people are first introduced to the terms Traditional and Roth when they are filling out the paperwork for their first job that has retirement plan benefits.  At this point, it becomes a daunting question and people often end up making selection based on limited understanding and knowledge.  While the specifics behind these accounts can get very complex, there are some basic rules that you can use to understand the difference without falling down a rabbit hole. 

The biggest and most consequential difference between a Traditional and Roth account is when you pay taxes on the money and what restrictions there are to access.  Understanding this can  help you to decide which type of account is better for your situation.

Contributions to a traditional account are not taxed in the year you contribute, but instead are taxed when you take out the money.  This increases the money available to you in the present because you are not giving that money to the government. The catch is this money is taxed as income when you take it out of the account and most professionals end up in a higher tax bracket in retirement than they were at the beginning of their career.  The early savings of a Traditional plan can lead to higher taxes once you reach retirement.  

Contributions to a Roth account do not receive tax benefits in the year they are contributed.  This means you won’t be getting a smaller tax bill when you contribute. While this means you may be spending more money in the present, you will not be taxed on the money when you take it out of the account.  This can have many advantages and can result in lower taxes in retirement.

The other important difference in the accounts is the early withdrawal penalty.  Retirement accounts are designed to put your money away until you reach 59 ½ and there are penalties to accessing that money before that age.  In a traditional account the penalties are on the entire amount of the account, in a Roth account the penalties only apply on a prorated basis to the earnings on the account for the amount withdrawn.  That means you can access your Roth contributions with fewer penalties than a traditional account, which can be a great advantage if you find yourself needing the money before you retire.  

Another complicating factor is that Congress can change the rules around these accounts and no one knows what that might look like.  Deciding which one is right for you requires a bit of predicting what you think will happen in the future and what and without a crystal ball that is difficult.  However, if you are starting your career, earning less than you think you will in the future, and have many years for the investment to grow or if you may need access to your contributions, a Roth may be more advantageous. If you are a very high income earner, a Traditional account may be the better choice. 

Every situation is different. There is no one perfect answer, but tax advantaged accounts are a tool that you can and should understand and use to optimize your investments.  Educating yourself or receiving guidance from a professional is one way to ensure that you are making the best decisions for your life.  If you are looking for help understanding any of these options, coaches at Value Driven Finance are here to help you.