After running financial planning workshops for thousands of women, I have found that the area with the most amount of questions and confusion surrounds retirement plans, specifically Traditional vs. Roth IRA. The first thing to note is that what differentiates the two plans is tax related. We’ll talk generally about the differences between them, but your retirement plan is only one part of your overall financial picture. I recommend speaking with a tax advisor or CPA (Certified Public Accountant) for specific advice about which option or combination is best for you.
So what does Roth mean? Roth is actually someone’s name - Senator William Roth - and it was introduced as part of the Taxpayer Relief Act of 1997. To understand the Roth IRA, it’s important first understand the Traditional method.
Why is it called Traditional? Quite simply, it’s the way it has been traditionally done (you’ve probably seen this in your 401(k) account). The money comes out of your paycheck pre-tax, so you don't pay income tax on that money now. Instead, it goes into your retirement plan and grows tax-deferred. When you retire and withdraw the money, you will pay income tax on it then. So if you look at your 401(k) balance and say it’s $50,000 - it’s not actually the full $50,000 because you’ve never paid tax on it.
The Roth is somewhat opposite of that. The contributions you make to your retirement plan today are after-tax, so you pay income tax on it NOW. Then it grows in your Roth tax-free so when you access it in retirement, you do NOT have to pay tax on the growth of your dollars. This is one of the few places left (along with 529 plans and HSAs) where you can get tax-free growth of your money. Tax-free growth is powerful because income tax can be really expensive!
The after-tax Roth concept started with IRAs (Individual Retirement Accounts). IRAs are your personal retirement accounts and you can have them just about anywhere - at the bank, through an app, at a brokerage firm, etc.
Who Can Contribute?
Unlike a traditional IRA, NOT EVERYONE CAN CONTRIBUTE TO A ROTH IRA. There are income limitations on making Roth IRA contributions, which means if you earn too much money, you will get phased out of contributing (see www.irs.gov for more info on the income limits). For all IRAs, there is a cap on how much money you can contribute each year - $6,000 for those of under age 50. This number is combined for all your IRAs, not $6,000 per account.
The Roth IRA has become very popular and understandably, the government likes collecting income tax today rather than 40 years from now. So much so that many company retirement plans now allow Roth provisions. To set up Roth contributions to your company plan, log into the website & look for where it asks how much you want to contribute pre-tax vs. post-tax.
The big difference for company plans is there are no income limits for contributing after-tax, so everyone can make Roth contributions to their 401(k) plan. The contribution to a company plan is higher than an IRA ($19,500 vs. $6,000 for those under age 50). Even if you make too much money to do a Roth IRA, there is still a way for you to get tax-free growth.
The Roth Conversion
Since the government likes collecting taxes, they allow for something called a Roth conversion. This is when you convert a Traditional or pre-tax IRA to a Roth one, meaning you pay the income tax when you do the conversion. This may make sense if you find yourself one year in a low income tax bracket (i.e. you got laid off or went back to school). I also see people do it with smaller IRA amounts since the overall tax implication would be negligible to their overall return. Important to note here, it’s not an all or nothing thing - you can convert as much or as little as you would like.
Unlike IRA contributions, where you can make them until you file your taxes in April the following year, the Roth conversion has to be done within the calendar year. Some company plans allow for in-service conversions. So if you are currently working for a company, you may be able to convert the pre-tax money in your plan. If your company matches, their contributions are done pre-tax.
The Back-Door Roth Contribution
There is a more complex tax planning technique called a Back-Door Roth IRA. In this scenario, you make too much money to contribute to a Roth IRA. Instead, you make a non-deductible Traditional IRA contribution and convert that money into a Roth. This is absolutely something to talk to your financial or tax advisor about before doing it since there are many nuances to make sure it's done correctly.
Should you do Roth or Traditional or both?
This is very much so a tax question. Will you be in a higher tax bracket now or in retirement? Factors to determine this include where will you live during retirement (in Florida with no income tax or a high tax state like NY or California?), how much money will you be making (you may continue to work part time, have rental income, Social Security, etc), and what will the tax code be? The tax code is certain to change multiple times over the course of our lives.
And so, there are a lot of projections and guesses about what the future holds to make this determination. This is why it’s crucial to bring in a professional like a tax or financial advisor to help guide you in making this decision.