How to Choose Between Roth IRA and Traditional IRA

Retirement Plan Options | by Jules Buxbaum | Sunday, January 05, 2025

Roth IRA vs. Traditional IRA—this question often puzzles individuals hoping to build a secure nest egg for retirement. If you’re aiming to minimize long-term taxes or simply want clearer guidance, you’re not alone. Learn more about the key tax implications of these accounts to make the best choice for your future.

Professionals, self-employed workers, and those with inconsistent income all wonder how each IRA impacts taxes, growth, and flexibility. Whether you’re striving for immediate tax relief or betting on higher rates in retirement, understanding each IRA’s rules can transform your overall financial plan.

Why IRAs Matter for Your Retirement

An IRA, or Individual Retirement Account, is more than just a place to stash funds. It helps you protect earnings from annual taxes, grow savings for decades, and potentially secure tax advantages along the way.

According to a study by T. Rowe Price, a 25-year-old earning $50,000 a year could end up with about 20% more after-tax retirement wealth by choosing the IRA type that aligns with their future tax bracket expectations. This statistic underscores how a well-chosen IRA can be pivotal in building a strong retirement plan.

If you’re feeling behind, you’re not alone. Many Americans find themselves unsure of the best moves to take. For more guidance on regaining ground, explore our insights on what to do if you’re behind on retirement savings.

Traditional IRA vs. Roth IRA: Key Differences

Both types let your money benefit from tax advantages, but the timing of those advantages differs dramatically. Below are the core elements that set them apart.

Tax Treatment

• Traditional IRA: Contributions can reduce your taxable income in the current year, but withdrawals will be taxed later as ordinary income. This arrangement appeals to individuals seeking immediate tax reduction.

• Roth IRA: Contributions occur after taxes, yet qualified withdrawals come out tax-free. This structure favors those who expect higher taxes in retirement or want to be free from required minimum distributions.

By the end of 2022, Americans held nearly $11.7 trillion in IRAs, comprising about 35% of the total U.S. retirement market. This widespread use reflects how crucial it is to pick the account type that best fits your financial and tax outlook.

Contribution Limits and Eligibility

For 2025, you can typically contribute up to $7,000 if you’re under 50, or $8,000 if you’re 50 or older. However, Roth IRAs have income phaseouts starting at $150,000 for single filers and $236,000 for married couples filing jointly. Traditional IRAs don’t have income restrictions for contributions, but your ability to deduct those contributions may be phased out if you or your spouse have a workplace retirement plan.

These details matter because your adjusted gross income could make one account more attractive or even restrict your Roth contributions. In that scenario, some investors turn to nondeductible Traditional IRA contributions and then convert them to a Roth IRA—a maneuver popularly known as a “backdoor Roth.”

When a Traditional IRA Might Work Best

Traditional IRAs can be ideal if you’re looking for an immediate tax deduction or if you anticipate a lower tax bracket in retirement. For example, imagine someone close to retirement who expects minimal overall income later in life. Reducing taxes now might deliver a higher overall benefit than paying taxes upfront.

Additionally, since this account type offers tax-deferred growth and deductible contributions (depending on income and plan coverage), many people find it’s still an effective way to save—especially if they’re juggling multiple financial goals. But be aware: starting at age 73 (rising to 75 in 2033 due to recent legislative changes), you must pull funds out via required minimum distributions.

Why Choose a Roth IRA

If you suspect your income or overall tax rates will be higher in the future, a Roth IRA may stand out. You pay taxes today but enjoy tax-free withdrawals in retirement—meaning your growth and distributions remain untouched by Uncle Sam.

Another advantage is that a Roth IRA doesn’t require withdrawals during your lifetime, allowing your money to keep compounding if you can afford to leave it untouched. And if you’re unsure whether you’ll be able to retire when planned, consider how early access to your contributions (not earnings) could serve as a safety net. Roth IRAs allow you to withdraw contributions tax- and penalty-free whenever you want, giving an added layer of flexibility.

On top of that, younger professionals who are still building earning power often find a Roth appealing. Their current tax rate may be modest, so making after-tax contributions earlier could save on taxes down the road.

Risk Tolerance and the Age Fallacy

Conventional wisdom suggests lowering risk in your portfolio as you get older. However, 2Pi Financial highlights that this idea isn’t always accurate. Many individuals actually need higher returns to finance a comfortable retirement.

Historically, equities have outperformed other asset classes for over 100 years, creating a built-in equity risk premium. 2Pi Financial believes that reduced risk with age isn’t an absolute must—your future earnings matter more than your age alone. If you have robust future earnings potential, you might handle a higher percentage of equities in your retirement portfolio, even later in life.

Early mistakes in planning can wreak havoc on your savings. To spot potential dangers, take a look at our guide on common mistakes to avoid when planning for retirement. By tailoring your IRA strategy to your career and financial trajectory, you can sidestep pitfalls from overly conservative assumptions.

Strategies for Combining Both IRA Types

Some people split their contributions between Roth and Traditional IRAs to achieve tax diversification. This approach can help you manage uncertainty—if tax rates trend up, your Roth funds are already tax-free; if rates fall, your Traditional funds provide savings.

Another approach: open a Traditional IRA if you qualify for immediate deductions, then shift to a Roth IRA in years where your income dips (for example, between jobs). This timed strategy might help you pay lower taxes on conversion while still building a tax-free bucket.

Because taxes can be a big factor in how effectively you draw down from IRAs, you may want further insights from our overview of how to minimize taxes on your retirement income. Each element of your plan can work together to reduce unnecessary tax obligations.

Real-World Scenarios and Statistics

• Higher-Earning Professionals: Individuals expecting significant future raises might choose Roth IRAs early, locking in lower tax rates for contributions. A T. Rowe Price study showed that choosing the right IRA can mean a substantial difference in retirement wealth—up to 20% more in certain cases.

• Mid-Career Switch: If you move from a high-paying role to self-employment with fluctuating income, a blended mix of Roth and Traditional IRAs can give you both immediate tax relief and long-term tax-free withdrawals.

• Late Savers Catching Up: Those discovering retirement saving a bit late in life often assume they must drastically reduce equity exposure. But if your future earning power remains strong or you plan to work part-time for years ahead, a balanced or even equity-leaning strategy could still make sense, especially if you anticipate a longer investment timeline.

These real-world use cases highlight the complexity and personalized considerations behind “Roth or Traditional?” Being aware of your future career path, current income level, and expected retirement timeline can shape your decision.

The 2Pi Financial Perspective

2Pi Financial’s core message is that asset allocation shouldn’t simply “gray” with age. Many investors shift to bonds prematurely, missing out on potential equity gains. If your situation includes robust earning power, you might be able to take on a higher equity stake in your IRAs, whether Roth or Traditional.

Instead of focusing on age alone, 2Pi Financial suggests focusing on the ratio between current wealth and future earning potential. A worker at 60 who has the ability to generate robust future income may have more capacity for equity exposure than a 40-year-old with minimal paycheck growth in sight.

FAQ: Common Questions

Q1: Should I convert my Traditional IRA to a Roth IRA?
It depends on whether you can handle the tax cost now for long-term tax-free growth. If you anticipate higher tax rates in retirement or want to avoid RMDs, a conversion may be appealing during a lower-earning year.

Q2: Can I contribute to both a Traditional and a Roth IRA in the same year?
Yes, but your total contributions across both cannot exceed the overall annual limit. Some people split contributions to diversify tax strategies.

Q3: What if I change my mind about my contribution type?
You can recharacterize contributions in certain circumstances. However, there are deadlines and technical steps to follow, so consult a tax professional if you want to alter your contributions.

Wrapping Up

Choosing between a Traditional IRA and a Roth IRA is deeply personal, shaped by tax considerations, time horizon, and how much risk you can handle. While conventional wisdom suggests reducing risk with age, 2Pi Financial highlights that your future earnings play a bigger role in how aggressively you invest.

If you’d like to explore a custom, data-driven approach, Two Pi’s Financial Planning Engine can help tailor a strategy to your retirement date, savings rate, and risk tolerance. This resource can also show you how adjusting parameters—like when you retire or how much you save—affects the probability that your money lasts.

Remember that tax rules evolve and personal circumstances shift. Consider your best mix of tax-deferred and tax-free contributions to stay flexible. For insights on managing mandatory withdrawals, check out our resource on understanding required minimum distributions. By combining informed decisions with proactive planning, you can put yourself in a stronger position for the road ahead.

References

1. T. Rowe Price. (2023). “Key Financial Numbers.” Available at: https://www.troweprice.com/personal-investing/resources/insights/key-financial-numbers.html

2. Investment Company Institute. (2023). “The U.S. Retirement Market, Second Quarter 2023.” Available at: https://www.ici.org

3. NerdWallet. (2022). “Roth vs. Traditional IRA: Which Is Right for You?” Available at: https://www.nerdwallet.com/article/investing/roth-or-traditional-ira-account