Table of Contents
Infographic: Roth vs Traditional IRA
Roth vs Traditional IRA for Beginners
Traditional vs Roth IRA: choosing the right one will leave you with dramatically more money.
But if you only look at the tax rates, you might end up with the wrong one.
I passed the CFP® exam at 16 and have helped millions improve their finances, and in 5 minutes I’ll help you pick the right one.
Books by Easy Peasy Finance
[This is an affiliate link: at no additional cost to you, we will earn a commission if you click & make a purchase]
Introduction: IRA (Individual Retirement Account) Basics
An IRA – or Individual Retirement Account – is not an investment, it is a tax-sheltered investment account. This is true for the Roth IRA and Traditional versions.
They both share the same basic structure. The government gives you special tax treatment on the money you keep in it – the only difference is when you pay taxes.
Roth IRA vs Traditional IRA Tax Treatment
With a Roth IRA, you deposit money that’s already been taxed – so your normal take-home pay – and it grows completely tax-free.
When you retire and pull it out, you don’t owe the IRS anything.
A Traditional IRA flips the tax timing.
You get a tax deduction the year you contribute, which means you’re investing pre-tax dollars. But you’ll owe tax on every dollar you withdraw in retirement.
Understanding this tax treatment of Roth and Traditional IRAs is the first step in understanding why one usually beats the other. But there’s an equally crucial part most people overlook.
Roth vs Traditional IRA: Which One to Pick
The choice between the two accounts comes down to this.
For most young earners, the Roth IRA is far better because your income tax rate today is probably the lowest it’ll ever be.
So you’ll pay tax when your tax rate is low, and will avoid tax later when your rate would be higher.
If you invest $200 a month from age 25 to 65 in the stock market, and you’ll end up with about $1.4 Million.
With a Roth IRA, every cent of this stays yours without any taxes, because you already paid taxes on the contributions. With a Traditional IRA, that same balance could cost you hundreds of thousands in taxes.
While studying for the CFP® exam, I learned that retirees routinely get blindsided by exactly this: a six-figure tax bill on money that they assumed was all theirs.
But there’s another reason to choose a Roth IRA.
A Traditional IRA comes with required minimum distributions, or RMDs, which means once you hit 75, the IRS forces you to withdraw a set amount every single year, and pay tax on it.
A Roth IRA has no RMDs at all, so your money keeps compounding tax-free.
Say you reach 75 with $1.4 million in a Traditional IRA. Your first forced withdrawal is around $57,000 whether you need the money or not, and you owe tax on all of it.
The bigger problem with this is what happens to Social Security.
That $57,000 counts toward the income test that the IRS uses to decide how much of your Social Security check is taxable.
If you cross $34,000 as a single filer, then up to 85% of Social Security payments are taxable.
But Roth IRAs have no RMDs and withdrawals are tax-free anyway, so it has no impact on the tax you pay on Social Security payments.
Yet another benefit of Roth IRAs is that you can withdraw your contributions at any age with zero penalties or taxes. While it’s not ideal, a Roth IRA can be a last-resort emergency fund.
The Exceptions
The one real exception is peak-income years.
If you’re in a higher tax bracket now than you expect to be in during retirement, a Traditional IRA makes sense because you’ll save tax when your tax rate is high, and will be taxed at a lower rate when you withdraw later on.
Also, if you earn more than the Roth IRA income limit, you cannot make contributions. So check to make sure you’re eligible.
Check this out to actually start growing the money in your Roth or Traditional IRA – it’s a complete step-by-step guide for beginner investors like you: The Right Way to Invest Your First $1,000 (That Builds Real Wealth)