Traditional vs Roth
Lesson in Course: Finance at work (advanced, 8min)
Retirement accounts provide tax benefits. What does a taffy-like candy have to do with retirement accounts?
What it's about: There are two types of retirement accounts, Traditional and Roth.
Why it's important: They both provide tax benefits, but at different times.
Key takeaway: Using both gives us greater flexibility when creating tax strategies for now and in retirement.
Now and Later is a bold fruit-flavored candy that first made it onto the candy scene in the 1960s. The name suggests we'll like them now and then want some more later.
Retirement accounts come in two flavors, Traditional and Roth. The difference between the two primarily comes down to the tax treatment of our contributions.
Tax benefits now
With Traditional retirement accounts, we receive our tax benefits now.
Contributions to Traditional retirement accounts are tax-deductible, which lowers our income taxes today. We defer the taxes, and eventually, we will pay them when we withdraw that money in retirement. These accounts are a good choice if we expect our income tax rate will be higher today than in retirement, which is usually the case.
Tax benefits later
With Roth retirement accounts, we receive our tax benefits later.
Contributions to Roth retirement accounts require us to pay taxes now, but we won't have to pay income taxes when we withdraw that money in retirement. Roth retirement accounts are situational and better suited for investing in riskier assets. If these riskier assets pay off, we won't have to pay any tax on the significant gains!
Let's say we bought only Tesla stock with our contribution.
- On 12/21/2015, we could have contributed $5,500 and bought 118 shares of Tesla's stock priced at $46.51 to sit in our account.
- Five years later, on 12/18/2020, this risky investment became worth $82,010 with shares valued at $695.00 per share!!
As long as we wait until retirement, we can withdraw the $5,500 contribution AND the $76,510 gain completely tax-free.
If we did this in a Traditional account, the $82,010 would be subject to income tax when withdrawn in retirement, paying anywhere from 20% to 35%. That is roughly $16,400 to $28,700 out the door instead of staying in our pocket.
Having both
We can have both account options set up. Just like our sweet treat, we can enjoy some of the tax benefits now and later. We could prioritize our contributions to our employer-sponsored plan, like a Traditional 401(k), and then invest more for retirement in a Roth IRA.
The 401(k) contributions allow us to benefit from deferring income taxes today while putting money in a Roth IRA enables us to invest more aggressively to take advantage of tax-free growth.
Actionable ideas
If possible, maximize your retirement savings by contributing to both Traditional and Roth retirement accounts. Having both will provide greater flexibility for coming up with tax strategies today and in retirement. Your contributions to Traditional accounts help lower your tax bill today, while Roth accounts are ideal for high growth and tax-free money later.
What's next
Learn how you can invest your retirement money in alternative assets like fine art, venture capital, startups, real estate, land, and more with an Alto IRA.
Supplementary materials
Glossary
Individual retirement accounts in which contributions can be deducted from our income taxes. The account grows tax-free; however, income taxes are owed when money is withdrawn in retirement.
Individual retirement accounts in which contributions are made with our after-tax income. The account grows tax-free, and no taxes are owed when money is withdrawn in retirement.