Roth IRA vs IRA – Which Should You Use?

A few weeks ago I mentioned the new 401k, IRA and Roth IRA limits for 2018. In 2021 401(k)’s got a $500 a year bump up to $19,500/year, but Roth IRAs and IRAs held steady with a limit of $6,000 a year combined. Figuring out which account to use can be tricky, but in this post, I’m going to highlight what I think will pay off the most for you in the long run.

How IRA Deposit Limits Work

Every year, you have a limit of $6,000 that can go into a Roth IRA or a traditional IRA. If you’re 50 or older then that limit will be $7,000 a year, but throughout this post, I’ll be using the $6,000 number. If you’re 50 or older just add $1,000 to this one – the rest of the math should be the same.

This $6,000 can be all in one account or split out between both accounts. For example, all of these would be valid ways of maximizing your IRAs:

• $6,000 in an IRA, $0 in a Roth IRA
• $0 in an IRA, $6,000 in a Roth IRA
• $1,000 in an IRA, $5,00 in a Roth IRA
• $3,000 in an IRA, $3,00 in a Roth IRA

The combined amount between these two deposited by you should not exceed $6,000 for the calendar year.

What If I have Multiple Accounts?

It’s possible that could have multiple traditional IRA accounts or multiple Roth IRAs. For example, you could have a Roth IRA through your work, and also have one set up on your own through Vanguard. Your work Roth IRA will not know about your Vanguard Roth IRA, and Vanguard will not know about your work Roth IRA.

Between these two Roths, the math will work out the same as above:

• $6,000 in your work Roth IRA, $0 in your Vanguard Roth IRA
• $0 in your work Roth IRA, $6,000 in your Vanguard Roth IRA
• $1,000 in your work Roth IRA, $5,000 in your Vanguard Roth IRA
• $3,000 in your work Roth IRA, $3,000 in your Vanguard Roth IRA

If you were to add a 3rd account to this (traditional IRA or Roth) then the math would still be the same just split over 3 accounts.

Each account will let you deposit up to $6,000 a year and should stop you from depositing more than the limit for the year. But if you are using multiple accounts at different brokerages, it’ll be your responsibility to make sure you don’t exceed the maximum.

Traditional vs Roth IRA Basics

The main difference between these two accounts all comes down to one question:

Do you want to pay taxes now (Roth IRA) or later (Traditional IRA)?

You’re going to need to pay taxes at some point, there is no way around that (but there are ways to minimize it!). My goal when deciding between these two is always to pick the situation that’ll require me to pay the least taxes while minimizing the likelihood of doing something wrong that would trigger an audit by the IRS.

My recommendation? If you can use a Roth IRA, use a Roth IRA! That’s especially true if you have a 401(k) already. 401(k)’s and traditional IRA’s are both pre-tax, and are the same in retirement.

Roth IRA’s are different – they give you additional flexibility in retirement allowing you to withdraw funds without paying taxes. (since you’ve been taxed already). By having money in both pre and post-tax accounts, you have can control how much tax you pay upon retirement by changing which accounts you withdraw from.

How Traditional IRA Tax Deductions Work

How tax deductions work for traditional IRA’s depends if you have a retirement plan offered through your work. Let’s look at both scenarios.

Without a Retirement Plan From Your Work

If your job doesn’t offer a 401k or other employer retirement plan (and your spouse doesn’t either if you’re filing jointly), then you can deduct the amount you put into a tIRA regardless of how much income you make. You’ll still be capped based on how much you can put into a traditional IRA.

For example, if you have an income of $50,000 from a job that doesn’t offer a retirement plan, you can put $6,000 into a tIRA and deduct it from your taxes – lowering your effective tax basis to $44,000. At that point, you’d get back the taxes you paid on that $6,000 when you filed taxes at the end of the year.

You can read more about the income tiers on the IRS.gov website.

If You Have a Retirement Plan From Your Work

If you make below a certain amount, you can deduct your Traditional IRA contribution from your taxes even if your employer provides a retirement plan. This deduction is similar to a 401k in that they’re “adjustment to income” deductions.

As for how to read this info from IRS.gov: look for your Filing Status, and find the corresponding AGI Limit. If you make under that amount, then you can contribute to an IRA and deduct that amount.

If you make between the AGI Limit and Phase Out Limit, then you could deduct part of your contribution – 0% at the high end. If you’re in this range, then you’re going to need to a do a lot more math to figure out how much you could deduct.

This deduction works differently than standard deductions. Deductions like mortgage interest, charitable donations, and state tax are part of your “Standard Deduction” for the year ($12,550 or $25,100 in 2021). The Traditional IRA deduction is something different though — it’s an adjustment to income that doesn’t count towards your standard deduction. Even with all the tax changes in 2018, you’ll still be able to deduct traditional IRA contributions.

Roth IRA Limits

To add more confusion to the pot, Roth IRAs have limits too! If you make over a certain amount (the AGI Limit in the chart below), then you won’t be able to directly deposit funds into a Roth IRA.

“AGI” is a bit of a weird term that the IRS uses. It’s the total income you earned in the past year from your job, minus certain adjustments. For most people, this amount will be their earned minus 401k contribution. AGI doesn’t take into account other standard deductions. The “Phase Out” part works similar to

The “amount you earned” will include things like capital gains and dividends, so it can balloon fast if you have a large number of investments.

If your AGI is over $125,000 (or $198 if filing jointly), you cannot contribute directly to a Roth IRA.

IRA or Roth IRA?

Which account to use will depend on many factors – now and in the future. Here are some of the main factors to think about.

Do you earn more than $125k/year (or $195k & filing jointly)?

If you earn more than $125k/$195k, then your only option is to invest in a traditional IRA, then not deduct it from your taxes. I can think of no reason why you would want to do that and leave the funds in a traditional IRA.

What you can do though is do a Backdoor Roth IRA. The idea here is you put $6,000 in your traditional IRA, then immediately convert that $6,000 into a Roth IRA. Since the money you put into your IRA was already taxed, there is no tax due when you perform this conversion.

It’s a glaring loophole, but there are some caveats:

• If you have a large balance in your IRA (from a 401k conversion for example), you may need to pay taxes when converting to a Roth. That’s because the money you’re moving into the Roth isn’t “last in first out”, but based on the cost basis for all of your IRAs combined.
• If you have any other funds in your IRA besides the $6,000 you would need to pay taxes.
• If you have other IRAs besides the one you’re using with any funds, you’ll need to pay taxes.
• If your funds increase in value in the IRA before converting to a Roth, you’ll need to pay taxes.

Do you think you’ll ever earn more than $125k/$195k a year?

This one will be really tough to predict early on, but if you think you’ll likely earn $125,000/year down the line (or $195k filing jointly), it could make sense to use a Roth IRA now. If you decided to use a traditional IRA now, then, later on, you were making more than $125k, then all a sudden you can’t do a Roth IRA conversion without paying taxes!

If you look at your career trajectory, with how many years you have left until you want to retire, and it seems likely you’ll need to use a backdoor Roth IRA someday in the future, you probably want to use a Roth IRA now.

Do you want the most flexibility in your retirement planning?

If you want the most flexibility, you’re going to want to use a Roth IRA whenever you have the option (or use a backdoor Roth IRA when you don’t). This is much more flexible down the line since withdraws from a Roth are kind of like magic. These withdrawals don’t increase your income – meaning that you could take as much out of a Roth (after you’re 59.5 years old) and it won’t be taxed.

This can come in extremely handy for adjusting your income for other things later. For example:

Roth IRA Superpowers

Let’s say you’re retiring and withdrawing $30,000 from your 401k and you also sell some stocks earning you a total of $10,000 with $5k in long-term capital gains. On this $40k, you’ll pay some taxes:

• ~$3,410.10 in income taxes on the $30,000 from your 401k.
• $750 on your capital gains.

Meaning you only get to keep $35,839.90 of your $40,000! The reason for this is because your capital gains were taxed at 15% since you’re in the 25% tax bracket. If you’re in the 12% tax bracket though, you would pay no capital gains tax (yeah, really!).

If you split this up to instead withdraw $1,300 from your Roth IRA, $28,700 from your 401k and $10,000 from your brokerage, the tax picture would look much different:

• $0 in taxes from your Roth IRA
• $0 in taxes from your capital gains
• $3,254.10 in income tax on the 401k withdrawal.

By substituting just $1,300 from your Roth IRA, you changed your income tax bracket and didn’t have to pay $750 in capital gains tax. In the end, you would get to keep $36,745.90! Or about $906 more! The possibility of using a Roth to tweak which income bracket you are in is an amazing superpower.

Side note: tax rates change every year, so use this as an example of how to lower your taxes.

Do you earn between $66,000 and $125,000?

If your earnings are in this sweet spot (or $105,000 and $195,000 if filing jointly) then you should use a Roth IRA. This is the easiest decision there is actually. There’s no reason to use a Traditional IRA if you’re making within this range.

Technically, you could put some money into a traditional IRA and some of it into a Roth iRA. The calculation of how much you could put into each isn’t something you can easily do until tax season. That means you’d be making your 2020 IRA & Roth IRA contributions sometime around March 2021 when you’re filing your taxes.

Since the markets historically go up about 10% a year, you’re better off investing this money in a Roth IRA.

If you’re not sure how much you’ll earn during the year, you could still contribute to a Roth IRA then after the year is over “recategorize” your contribution as an IRA contribution rolled over to a Roth. I called up Vanguard to do this a few years back when rebalancing my investments put me above the limit. They changed some settings on their side and somehow my contributions were in the right buckets.

I’d prefer not to have to do this, but it’s nice to know it’s an option.

Do you earn between $38,700 and $63,000?

If you’re in this income rate (or between $77,400 and $101,000 if filing jointly), then this is the one income bracket where investing in a Traditional IRA and deducting the contribution could actually make sense!

The idea is that if you’re in this range, you’re in the 25% tax bracket and could see yourself in a lower tax bracket when you retire. I’m personally counting on being in the 12% tax bracket when retiring based on my Financial Independence with Options number. Because of this, it would make sense to take the tax deduction now (25%) rather than later.

Here’s a look at what the tax brackets look like for 2021 with the new tax bill.

2018 Income Tax Brackets

So does that mean if you’re in this range you should use a Traditional IRA? Well, only if you don’t meet the

• Do you think you’ll ever use a backdoor Roth IRA? If so, just use a Roth IRA now anyways.
• Do you think you’ll be in a higher tax bracket upon retirement? If so, just use a Roth IRA now.

When in doubt, use a Roth IRA if you can!

Example Comparison of a Traditional vs Roth IRA

If you’re still wondering “should I use a Traditional IRA or Roth IRA?” let’s look at an example. For this first one, let’s assume a few things:

• You’re in the 25% tax bracket or higher
• You’ll be in the 25% tax bracket or lower when you withdraw funds.

Why is the tax on the IRA so much lower than the Roth IRA? Well, let’s think about how taxes are evaluated. It’s not a simple calculation of $41,867.40 x 25%. Instead, you have to tax each tier of the amount:

For Single Tax Filers

• 10% tax for the first $9,950 ($9,950 * 0.1) = $995
• 12% tax for $9,520 to $40,525 (($40,525-$9,950)*0.12) = $3,669
• 22% tax for $40,525 to $45,673.53 (($45,673.53-$40,525)*0.22) = $1,132.67

That brings the total tax to the $5,796.67 in the table above, making it the clear winner for take-home amount in this scenario.

If you’re filing jointly, you’d pay less taxes – only $5,082.82.

If your tax rate is lower upon retirement, then the amount you’d gain by using a Traditional IRA will be even more.

And you have a bunch already in an IRA

Another use case for a Traditional IRA would be if you already have a lot of funds in the account from a 401k rollover. If you’re in this situation, contributing to a Roth IRA would likely mean paying more taxes. If you’re in this salary range where you’re able to deduct an IRA contribution and you already have a bunch of money in an IRA, then I’d say go for it.

You’re going down a path where you likely won’t want to do a backdoor Roth IRA, but you could tax the tax savings today and get a bit of extra money to invest.

What do I Use?

I have $0 in a Traditional IRA. At one time in my life, I had an IRA that was rolled over from a 401k that I then converted to a Roth IRA while I was still in a lower income bracket than I am now.

Today I prefer to use a Backdoor Roth IRA each year at the beginning of the year. I can see some situations where a Traditional IRA could make sense, but they’re few and far between. Chances are, you’re going to want to use a Roth IRA or just a brokerage account.

If you are in the sweet spot and don’t expect to earn a high enough salary to require a Backdoor Roth IRA down the line, then a Traditional IRA with a deduction can net you an additional 7% to 12% on your investment.