Traditional vs Roth: What’s the Difference?
A question that often arises when investing for retirement is “What’s the difference between Traditional and Roth?” Surprisingly the answer isn’t as complicated as most people think.
Regardless, it’s an important answer to know and understand because it often guides the decision on which makes sense for you.
Note: Traditional and Roth are the tax type of “tax-advantaged” accounts and exist inside of IRAs, 401(k)s, 403(b)s, 457 plans, etc.
Taxation
The main differences between Traditional and Roth is when the contributions and earnings are taxed.
It’s important to know that you can have both Traditional and Roth accounts as well as make both types of contributions as long as you qualify and abide by the limitations.
Traditional
Traditional contributions, often cited as pre-tax or tax deferred, means that you get a tax deduction in the year that you contribute to that Traditional account. You are “deferring” the payment of taxes until the future when you withdraw the money.
Put this in a separate box/element off to the side(If dealing with an IRA, you may contribute to the prior year if done before the tax filing deadline for that prior year. For example, if you want to make an IRA contribution for 2023 then you may do so up until the 2023 tax filing deadline which would be mid-April of 2024.)
For example, if you gross $200,000 in income and make $22,500 in Traditional contributions to your 401(k) then you will actually report $$177,500 on your taxes and subsequently only pay tax on that $177,500.
The caveat with Traditional money, contributions and earnings, is that it’s taxed when it’s withdrawn from your account.
For example, if you withdraw $50,000 from your Traditional IRA then $50,000 will be reported as taxable income for both your federal and state taxes.
As the industry puts it, “You’re taxed on the harvest.” Or in other words, you’ve deferred taxes in the past, your account has grown, and now you pay taxes on what’s withdrawn from it.
Roth
Roth contributions are the exact opposite of Traditional and are made with after-tax dollars that you’ve already paid taxes on.
Therefore, your money (contributions and earnings) grows tax-free and is withdrawn free of taxes and penalties as long as it’s a qualified distribution (more on this later).
As the industry puts it, “You’re taxed on the seed.”
Finally, one unique aspect of Roth accounts is that since the contributions have already been taxed you can actually withdraw the contributions, as an early distribution, any time with some caveats.
Roth IRAs
For Roth IRAs, you can withdraw any and all contributions tax-free. In fact, all contributions are withdrawn first until you’ve withdrawn all your contributions in which earnings are then withdrawn.
Roth 401(k)s
For Roth 401(k)s, an early withdrawal is prorated between the total contributions and earnings. Also, the earnings portion of any early withdrawals are subject to a 10% early withdrawal penalty and income taxes.
So for example, if you have a Roth 401(k) made up of $90,000 of contributions and $10,000 of earnings then you have a 10% earnings ratio (or a 90% contribution ratio).
$10,000 (earnings) / $100,000 (total account value) = 10% (earnings ratio)
$90,000 (contributions) / $100,000 (total account value) = 90% (contribution ratio)
If you decide to withdraw $10,000 from your Roth 401(k) then it will be prorated based on the aforementioned ratios which would result in $9,000 being allocated towards contributions and $1,000 being allocated towards earnings.
10% (earnings ratio) x $10,000 = $1,000 (earnings proration)
90% (contribution ratio) x $10,000 = $9,000 (contribution proration)
The $1,000 in earnings will be subject to a 10% early withdrawal penalty and income taxes.
An Important Note
One thing I’d like to point out is that neither Traditional or Roth is better than one another. Rather, both should be viewed as tools that have specific times when they provide more value than the other.
So it’s never either or but rather when is it best to use one over the other.
One interesting fact that many don’t know is that when it comes to taxation they will both get you the same result all things being equal. Check out the example below.
The Restrictions and Limitations
One thing to understand is that there are restrictions and limitations when dealing with both Traditional and Roth accounts.
Contributions
IRAs
The annual maximum IRA contribution is the same regardless of if it’s Traditional or Roth.
For 2023, that annual limit is $6,500 with an extra $1,000 catch up contribution for those over the age of 50.
This is also an aggregate limit so you can make any combination of Traditional and Roth contributions.
Traditional
For those that are active participants in their workplace retirement plan (e.g. 401k) then there are Traditional IRA deduction phaseout limits based on Modified Adjusted Gross Income (MAGI). In other words, the IRS doesn’t want you deferring too much income.
A phase out limit is the gradual reduction in your ability to claim a deduction, credit, or make a contribution. (side element)
The IRS defines “active participants” as this:
“If your plan is a 401(k) plan, active participants include those individuals who are employed at any time during the year in question and are eligible to participate in the plan even if they elect not to make contributions to the plan. Do not include participants who terminated employment in prior years.”
Here are the 2023 phase out limits for contributing, and deducting, Traditional IRA contributions:
Single: $73,000 - $83,000
Married Filing Jointly: $116,000 - $136,000
Married Filing Separately: $0 - $10,000
Non-active participant married to active participant: $218,000 - $228,000
Roth
There are also phase out limits for contributing to a Roth IRA. The beginning of the phase out limit is when the eligible contribution begins to be reduced with no contribution being allowed once you hit the top of the phase out limit.
Here are the 2023 phase out limits for contributing to a Roth IRA :
Single: $138,000 - $153,000
Married Filing Jointly: $218,000 - $228,000
Married Filing Separately: $0 - $10,000
401(k)s
There are no income limitations for contributing to a Traditional or Roth 401(k). This is extremely beneficial to high income earners.
The 2023 annual elective deferral limitation for 401(k)s is $22,500 with a $7,500 catch up contribution for those over the age of 50.
Like I mentioned with IRAs, the annual limit is an aggregate limit so you may choose to contribute to a Roth 401(k) and Traditional 401(k) in whatever combination you choose (if you have both available to you).
Distributions
When it comes to tax advantaged accounts, the distributions can be either qualified or non-qualified.
Qualified
Qualified distributions are those that meet the criteria for the appropriate account. Qualified distributions are free from penalties but taxes may still be owed depending on if the distribution is from a Traditional account.
Traditional
To be a qualified distribution from a Traditional IRA or Traditional 401(k) the distribution must occur after age 59 ¹/₂.
Roth
To be a qualified distribution from a Roth IRA:
The owner of the Roth IRA account(s) must have had their first Roth IRA open and funded for at least five tax years. Tax years count from January 1 of the first tax year when a contribution was made.
The distribution of any Roth conversions must have happened after at least five tax years from when the conversion occurred. Remember the start date that is used to determine the tax year is January 1 of the year of conversion.
The account owner must be 59 ¹/₂
It’s important to know that there are special exceptions and considerations when it comes to withdrawing funds from a Roth IRA without incurring a penalty. These exceptions and special considerations may include:
The account owner must be permanently disabled
The withdrawals are taken from an inherited Roth IRA account
Or taking up to $10,000 as a first-time homebuyer
To be a qualified distribution from a Roth 401(k):
The owner of the Roth 401(k) account must have had their first Roth 401(k) open and funded for at least five tax years. Tax years count from January 1 of the first tax year when a contribution was made.
The account owner must be 59 ¹/₂
Special exceptions and considerations for withdrawing funds from a Roth 401(k) without penalty may include:
The account owner must be permanently disabled
The withdrawals are taken from an inherited Roth 401(k)
Non-Qualified
Non-Qualified distributions are those that DON’T meet the above criteria for the appropriate account. Non-Qualified distributions are not free from penalties or the appropriate taxes.
Non-Qualified distributions are subject to a 10% early withdrawal penalty and any income tax that may be due.
Traditional accounts = income tax due on all money withdrawn
Roth accounts = income tax due on all growth and earnings
Should I Make Traditional or Roth Contributions?
As with most anything within personal finance: it depends.
I will say that this is a question that should be asked every year because the answer may change year to year depending on your situation.
You also want to focus on the goal of reducing the tax paid over your lifetime and not just the current year. Play the long game.
Determining which type of contribution you make depends on your income, anticipated income, marginal tax bracket, anticipated tax deductions and credits, and more.
An often cited factor is if tax rates will go up in the future. We cannot control what the government does with future tax brackets, we can only control what’s available to us today.
This is all to say that there isn’t a universal or absolute answer to what you should do year after year. It depends.
Roth contributions, or even conversions, can be good for low income years where you fall into lower tax brackets. This could include:
a spouse transitioning to stay at home with children
a sabbatical year
career transitions coupled with time off
years without bonuses or supplemental income
and more
Traditional contributions can be good for high income years and reduce taxable income in order to fall into a lower tax bracket or prevent climbing into a higher tax bracket. This could include:
restricted stock units (RSUs) vesting
exercising options incentive or non-qualified stock options (ISOs and NSOs)
alternative minimum tax due
taking required minimum distributions on inherited traditional accounts
the sale of appreciated investments and assets
and more
There you have it. I hope this article has been valuable to you in educating you on the differences between Traditional and Roth contributions as well as the more applicable types of accounts (e.g. IRAs and 401ks). Again, both Traditional and Roth are tools that should be used based on which will provide more value to you when planning your future finances. When in doubt, don’t hesitate to get a professional opinion or assistance!
