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Traditional And Roth Accounts: What's The Difference

Should you be using traditional or Roth retirement accounts? Do you know the difference? If not, don't worry; many people don't and even those who do may not be using them correctly.


Retirement Account Types


We have access to different types of accounts to help us save for different goals, such as health care costs (Health Savings accounts) or education (529 plans). Another type of account is a retirement account. We are able to put money away for our retirements and tax incentives exist to get us to do so.


Even though that sounds quite easy, there are so many choices of retirement accounts. There are 401(k) plans, 403(b) plans, individual retirement accounts (IRAs), 457(b) plans, Roth IRAs, Roth 401(k) plans, Roth 403(b) plans, Roth 457(b) plans and more (believe it or not). How are we supposed to know what to do?


All these accounts are very similar in tax treatment. The main difference is between those that are labeled as "Roth" accounts and those that are not. Those that are not called Roth accounts I will be calling traditional accounts for our purposes.


Traditional


Traditional retirement accounts work like this. You get a tax break on the money that you deposit into the account. Then your money gets to grow tax deferred, meaning you don't pay any taxes on the gains (dividends, interest, capital gains) while the money is in the account. You only pay taxes when you withdraw your money.


Roth


Roth retirement accounts, on the other hand, do not get a tax break up front. You deposit your money after you have already paid income tax. Your reward for not getting a current tax break is that your money gets to grow tax free, AND you do not pay any taxes on the money when you take it out.


All Else Equal


So with a traditional account you pay no taxes until you need the money and with Roth accounts you pay tax now and then never again.