Roth vs Traditional IRA

By Harper Willis

Most people who roll their 401(k) money over into an IRA choose a traditional IRA. But for some folks, it makes sense to choose a Roth IRA instead.

Take note: If you move 401(k) assets into a Roth IRA, you’ll owe taxes on the full amount of the rollover—which means you have to come up with a sizable slug of cash. And that cash shouldn’t come from your retirement assets, since that would mean giving up future tax-favored growth.

That’s a deal breaker for some folks. But you can reduce the impact of this rule by choosing to roll over only a portion of your 401(k) balance to a Roth. What’s more, there may be significant reasons to go for the Roth conversion if you have the cash.

That said, it’s important to understand the difference between the two types of IRAs before you make your choice.

Tax-free versus tax-deferred

Traditional IRAs are tax-deferred accounts. As such, they allow you to defer paying taxes on money you contribute and on earnings within the account. But you’ll have to pay taxes on that money when you withdraw it from the IRA.

Roth IRAs are tax-free accounts. You pay tax on the money you contribute, but that money grows tax-free within the account. You will never pay taxes on the earnings in a Roth IRA.

A traditional IRA gives you a head start. Let’s say you can afford to invest $2000 of your pretax income towards retirement. With a traditional IRA, you avoid taxes on that income. But you’ll have to pay taxes on those returns and on your original contribution when you withdraw the money.

By contrast, let’s say that you decide that you’re going to contribute to a Roth IRA. In that case, the $2000 you have aside for retirement savings is included in your taxable income for the year. That will leave you $1400 to invest (assuming you pay 30% in taxes). The good news: When you eventually decide to withdraw money from the Roth account, you pay no taxes on the contribution or on your earnings.

The big question: Which is more valuable to you? Is it the traditional IRA’s immediate head start, or the future tax-free withdrawals on the Roth IRA?

The answer depends upon a number of factors. Here’s what to consider.

Will you be in a higher tax bracket in retirement than you are now? If so, that is a point in favor of choosing a Roth. The higher your tax bracket in retirement, the more valuable the ability to make tax-free withdrawals from a Roth IRA. Likewise, the lower your tax bracket now, the less valuable the deduction on your current contributions.

How long before you will make withdrawals from the plan? The longer your money has to grow, the more earnings you’ll accumulate—and the greater your ability to take advantage of the tax-free withdrawals in a Roth. That’s why Roth IRAs often are an obvious choice for younger investors.

But even older investors who can afford to leave their retirement money untouched for a significant period may do well in a Roth. Whereas traditional IRAs require minimum distributions at age 70 1/2 , Roth IRAs do not. That means your money can grow tax-free in a Roth long after you reach retirement age.

Do you plan to leave substantial retirement assets to your heirs? If so, that’s another point in favor of a Roth. Spouses who inherit Roth IRAs do not have to take required minimum distributions, as they would with a traditional IRA. And non-spouse beneficiaries of a Roth IRA can elect to take the money out of the account in annual increments over a sustained period, as long as it doesn’t extend beyond their lifetimes. That means the money in the account can continue to grow tax-free for decades—a huge benefit to future generations.

In short, the decision between a rollover into a traditional or Roth IRA gets pretty complicated—but the stakes are high. Best advice: Work through these issues with your family—and with a trusted financial advisor—before you make your choice.