Roth versus traditional IRA

If you tally the total cost of your retirement, it's probably the biggest bill you'll ever pay. It may also be your goal with the longest lead time. An important tool to help save for retirement is an individual retirement account, or IRA. There are two popular types of IRAs: Roth and traditional. Each offers its own tax benefits and is worth considering when retirement planning. But understanding which one is right for you can be confusing.

To help determine what works for you, let's first cover the basics. Then we'll dive into an analysis that compares Roth and traditional IRAs through some examples showing you how to maximize your savings and minimize your taxes.

IRA basics

An IRA is an account that holds assets like cash, stocks, bonds, mutual funds and exchange-traded funds (ETFs). IRAs are meant to help you save for retirement and offer various tax benefits depending on which type you choose.

Think of an IRA as a garage. A garage may hold a motorcycle, minivan, sports car, and a bicycle. Just like the vehicles in a garage, the assets kept in an IRA can help achieve a retirement goal but at differing speeds and with varying risk levels.

The biggest difference between Roth and traditional IRAs is when taxes are paid. Roth IRA contributions are made with after-tax dollars, meaning they have already been taxed as part of your income. However, earnings grow tax free, and withdrawals aren't taxed as long as certain requirements are met.

Traditional IRA contributions may be tax deductible, depending on income level. A tax-deductible contribution to an IRA can lower your taxable income. Traditional IRA contributions grow tax-deferred, meaning taxes are not due until money is withdrawn from the account. But you pay taxes on the contribution and the growth.

Contributions to IRAs

Contributions to an IRA must be from earned income, which is money made from working or running a business. IRA contributions can't be made with passive income, which includes earnings from investments, Social Security, pensions or VA disability. This means that children who have earned income from a part-time job or even babies who earn money from modeling can contribute to an IRA.

Both Roth and traditional IRAs have income and yearly contribution limits. The limits may differ depending on your age and income and can change from year to year, so check the IRS website for the most current information.

Other retirement IRA considerations

Withdrawal restrictions

Although there are some exceptions, you're generally encouraged to not take money out of an IRA until age 59½.‍ ‍ ^{See note 1} The IRS discourages you from taken money out before that age by adding an additional 10% tax, sometimes viewed as a penalty for early withdrawal. These are supposed to be funds for retirement, after all.

However, Roth IRA contributions can always be accessed since that money has already been taxed. But an additional tax or “penalty” can apply to the earnings if the Roth IRA is less than five years old and you're not yet 59½.

Early distribution exceptions apply for people who become permanently disabled, first-time home buyers, and military reservists called to active duty, among others. If you need your IRA money early, first check to see if any exceptions apply.

Required minimum distributions

The rules for required minimum distributions, or RMDs, have changed over the years. USAA can help you understand how RMDs work.

But one key thing to note is that since the original Roth IRA owner is not subject to RMDs, this allows for more flexibility in retirement and estate planning. If the money isn’t needed for retirement income, a Roth IRA owner can leave it in their account and use it later in life or even pass it on to a selected beneficiary upon death. Although any remaining amounts in a Roth IRA after the owner's death are subject to RMDs, the distributions are tax free.

Roth versus traditional IRA: Tax differences

Roth and traditional IRAs offer tax advantages for long-term savings, but the benefits differ.

When deciding if a Roth or traditional IRA is right for you, it's important to consider your:

1. Time horizon.
2. Investing style.
3. Anticipated tax rate change in retirement.

Time horizon and investing style

When a larger percentage of the account balance is made up of growth, a Roth becomes more favorable. This is the case for those with longer time horizons and those with more aggressive investment styles, both of which can lead to more growth in the account. With a less aggressive investing style or a shorter time horizon, which tend to have less anticipated growth in the account, the value of a traditional IRA becomes more apparent.

Tax rates

For those who anticipate a significant decrease in tax rates between their current income and their retirement income, a traditional IRA may be more advantageous. The idea is that if they get a tax deduction at the higher current rate, they then pay taxes on withdrawals later when in a lower tax bracket. For example, a high earner who is currently taxed at 25% but expects retirement income to be taxed at 10% might consider a traditional IRA to defer paying taxes until they're in a lower tax bracket.

On the other hand, if there is not a big drop expected, retirement taxes or tax rates might even increase in the future and a Roth might become more favorable.

As you can see, it can quickly become a guessing game. But we've created a few examples to illustrate the benefits of the different IRAs to help guide your decision. It's important to note that these are just examples to illustrate key points. Work with a qualified financial advisor to run these types of scenarios with your personal situation and assumptions.

Example A: 20-year timeframe with 25% tax rate during working years and 10% in retirement

Meet Anna and Paul. They both earn the same income and contribute $6,000 per year to an IRA that's earning a 6% return. They begin saving at age 45 with plans to retire at age 65. Anna contributes to a traditional IRA and Paul to a Roth IRA.

Since they contribute and earn the same amount over the 20-year period, their IRAs end up with the same final value, more than $220,000. But there's a big difference in how much tax they pay and when they pay it. Also, in these examples, we're not factoring the time value of money considerations when taxes are paid.

Since her traditional IRA contributions are tax deductible, Anna lowers her annual tax payment by $1,500 each year ($6,000 multiplied by 0.25%), which equals a $30,000 tax savings over the 20 years. When Anna withdraws her money, she pays 10% taxes on the entire balance, which totals just over $22,000.

By investing in a traditional IRA and taking advantage of the upfront tax deductions, Anna has saved almost $8,000 in taxes on her final retirement balance.

Paul receives no tax breaks for his Roth IRA contributions, so he pays $30,000 in taxes on his Roth IRA contributions. But since he doesn't pay taxes when he withdraws the money, his tax bill stays at the $30,000 paid in the past. In this case, when accounting for Anna's tax deduction and her account being taxed at a lower tax rate, Paul pays approximately $38,000 more in taxes than Anna.

This illustrates the case that in shorter time horizons or when you have a large drop in tax rate at retirement, a traditional IRA tends to be more favorable.

This example may make the traditional IRA seem like a no-brainer, but examples B and C show how things change when tax rates are closer and when there's more time for earnings to accumulate.

Example B: 20-year timeframe with 25% tax rate during working years and 20% in retirement

This example shows that the closer the tax rates between your earning and retirement years are, the more the benefits lean closer the Roth IRA due to the decrease value of the upfront tax deduction.

At a 25% tax rate, Anna's tax savings is the same as in Example A at $30,000 over 20 years. Now that she's at a 20% tax rate in retirement, she'll pay $44,034.71 in taxes on the final account balance leaving her with a total tax bill of $14,034.71.

Paul paid the same taxes as he did in example A. However, the difference between Anna and Paul has decreased to just over $15,000 down from almost $38,000, illustrating that the closer the tax rates are during your working and retirement years, the advantage of the traditional IRA begins to disappear.

Example C: Same tax rates as Example B but with a 40-year time frame

Now let's repeat Example B but instead of beginning to save at 45, both Paul and Anna start saving for retirement when they're 25.

This example shows that Roth IRAs tend to be more favorable to those who are younger and have longer time horizons, as there's greater potential for growth due to the principal of compounding.

In this scenario, Anna receives the $1,500 annual tax deduction for 40 years, saving $60,000 in taxes during that time. When she pays her 20% tax rate on the final account balance of over $928,000, she pays approximately $185,000 in taxes. This leaves her with a total tax bill of just over $125,000.

Since Paul is taxed only on contributions, he pays $60,000 in taxes. In this case, Paul pays approximately $65,000 less in taxes than Anna. Also, Paul has increased flexibility in retirement since he isn't required to take RMDs, and he can freely withdrawal from his Roth IRA in retirement without worry of being bumped up into a higher tax bracket.

As these examples show, the decision between Roth or traditional IRA can quickly change based on each person's unique situation and assumptions. Changes in tax bracket, time horizon or growth can lead to choosing one over the other. This makes it almost impossible to make a "perfect" decision, so don't worry about being perfect.

For some, it might even be a good idea to "hedge their bets" by breaking up their yearly contributions, half into the Roth and half into the traditional. Either way, they'll accomplish what many people do not, which is saving for retirement. Hopefully, this will help them enjoy the peace of mind that comes with financial security during retirement.