Traditional vs Roth IRAs: What’s the Difference?

There are so many different types of retirement accounts out there that it can be pretty tough to keep them all straight.  It can be particularly tough to know which type of account is right for you.  In this month’s blog, I’ll explain the basics of a retirement account, and the differences between the three most common types so that you can make more informed decisions about what’s right for you.

Retirement Accounts vs. Standard Investment Accounts

Retirement accounts (401Ks and IRAs) are established and regulated by the federal government to encourage Americans to save for their future, primarily through tax savings or deferral. However, these perks come with restrictions, the most notable being a 10% penalty for withdrawing funds before age 59½. By choosing a standard investment account instead, you may sacrifice some tax benefits but gain greater flexibility.

Standard accounts are investment accounts that have no tax incentives or restrictions.  These types of accounts are often used for savings goals other than retirement.  Unlike retirement accounts, you can deposit or withdraw any amount of money at any time from a standard investment account, but you'll pay taxes along the way. For instance, dividends from stocks or a $2,000 gain from selling bitcoin would be taxable that year. In contrast, retirement accounts let dividends and capital gains grow tax-free, which is why most people rely on them for long-term savings, despite the inability to access funds freely like in a standard account.

Similarities Between Traditional IRAs and Roth IRAs

Two of the most common retirement accounts are Traditional IRAs and Roth IRAs.  When it comes to contributing to these accounts, the Tax Code puts very specific contribution limits for each calendar year.  Those contribution limits, listed below, are the same for both Traditional IRAs and Roth IRAs.

Differences Between Traditional IRAs and Roth IRAs

While the contribution limits for Traditional and Roth IRAs are the same, the differences between these two types of accounts are extensive.  For the purpose of this blog, I’ll describe the two most important differences. The first has to do with when you pay your taxes.  I refer to this as “pay now or pay later”.  The second has to do with how much flexibility you have when you want to pull funds out prior to reaching age 59 ½.

When you add money to a Roth IRA, you don’t get a tax benefit in the current year.  Once you retire, however, you can withdraw as needed without paying any taxes whatsoever.  So, with a Roth, you pay the taxes now with the expectation of enjoying more tax-free dollars during retirement.  Alternatively, when you add money to a Traditional IRA, you get a tax deduction in the current year, but you’ll pay regular income tax on any withdrawals you make later.  So, with a traditional IRA, you pay the taxes later.  It’s important to point out that neither option is magically erasing taxes, they just give you options on when you pay the taxes. 

Since Roth IRAs don’t offer any tax savings in the year you make the contribution, the Federal Government offers a lot more flexibility on when you can pull the funds out relative to a Traditional IRA.  There are only two restrictions when it comes to pulling funds out of Roth IRA’s penalty free prior to reaching age 59 ½.  First, five years has to have passed since you first contributed to the account and second, you can only pull your principal out penalty free prior to reaching age 59 ½.  For example, if a person contributed $100,000 to their Roth IRA between age 22 and 42 and they decide they want to take a risk on a start-up business, they can pull that $100,000 out tax free and penalty free.  This greater flexibility is one of the primary advantages to contributing to a Roth IRA.

Alternatively, due to the benefit of tax deferral, Traditional IRAs are much more restrictive when it comes to pulling funds out prior to reaching age 59 ½.  There are several crisis type situations where you’re allowed to withdraw funds without a penalty such as a total permanent disability or unreimbursed medical expenses, but the only positive reasons you’re allowed to pull money out of your Traditional IRA prior to age 59 ½ without a penalty are, $5,000 for a qualified birth or adoption, qualified higher education expenses (bad idea), $10,000 for a first time home purchase, and a rollover to a Roth.  That’s it!  So, generally speaking, Traditional IRA’s are a better deal in the current year while a Roth IRA is a better deal in the future.

How Does My 401(k) Fit into All of This?

Think of your 401(k) us a retirement account provided by your employer.  401(k)s have a lot of similarities to IRAs, but they’re completely separate.  If your employer has a 401(k), you can contribute to your 401(k) and either a Traditional IRA or a Roth IRA.  Most 401(k)s will have a traditional option and a Roth option.  These options have the same pay now or pay later principal as Traditional and Roth IRAs, but there is one very big difference: an employer provided match.  An employer provided match enables your employer to receive a tax deduction for contributing to your Traditional 401(k).  It’s called a match because they will “match” the amount you put in your 401(k) up to a limit.  So, if your employer matches up to 5% of your annual income of $100,000, they will put up to $5,000 in your account when you contribute $5,000 or more. 

It’s important to point out that your employer only gets a tax deduction for putting money in your Traditional 401(k) account since there are no current year tax deductions for Roth contributions (remember Roth accounts are “pay now” accounts).  It’s also important to emphasize that contributing to your 401(k) does not preclude you from contributing to your IRA each year.  The contribution limit for a 401(k) in 2026 is $24,500 ($32,500 if you’re over 50) so you can contribute $32,500 to your 401(k), (either Traditional IRA or Roth) and $8,600 to either a Traditional IRA or Roth for a total of $41,100.

Why do I Need to Know This?

If this feels like “Greek” to you, don’t worry.  Retirement accounts are complicated and we’ve only discussed a few of them.  There are SIMPLE IRAs, SEP IRAs, and owner only 401(k)s just to name a few.  A good financial advisor can help you evaluate your options and make an informed decision on which types of accounts to fund (I’ll unpack this more in a future blog).  There are two things I’d like you to take away from this discussion.  First, retirement accounts are a language that anyone can learn and even master; it’s just a matter of getting familiar with some important terms.  Second, the Traditional and Roth options, both in your 401(k) at work and in your IRAs allow you to pay the taxes now or pay the taxes later which is to say, you can decide to defer or delay a portion of your taxable income to a later day.  This ability to choose to delay is a powerful and legal tool that the Federal Government has made available to help you save taxes throughout your life and it’s constantly overlooked by investors and even financial professionals.  In next month’s blog, we’ll discuss how to use Traditional and Roth contributions to save yourself on taxes both while you’re working and when you’re retired.  We’ll even explain how being strategic with these two types of retirement accounts can save your heirs taxes, so be sure to keep an eye out for next month’s blog!