What’s a ROTH Account and Why Does it Matter?

There are few inevitabilities in this world, certainly death and taxes. We’re going to skip the former and talk about the latter: Taxes, and why it matters when decided which type of retirement account to choose.

A Tale of Two…Accounts

In the world of tax advantaged retirement accounts, there are two main types that you can have: Traditional or ROTH. The big differences between the two are when taxes are recognized on the accounts. The great feature that both types of accounts share is that earnings recognized (dividends, capital gains) in the account aren’t taxed.

What’s the Deal with Traditional 401k’s or IRAs?

For a Traditional Retirement Account, contributions made to the account are pre-tax dollars, which means that these contributions aren’t taxed and also reduce your tax exposure for the tax year in which they are made. You can’t avoid taxes forever – when you do take a withdrawal from a Traditional Retirement Account, you will pay taxes on that as income.

Most suggest that when you are in your higher income earning years, you should contribute to a Traditional retirement account to defer taxes until withdrawal. This is based on the theory that you’ll have a lower overall tax burden in retirement than when you are working. For example, say you make $300,000 – your effective tax rate (taxes paid/gross income) will be higher than when you take withdrawals in retirement from your various accounts. This is very much based on your personal situation, but it can be used as a general guide.

How about a ROTH 401k or IRA?

ROTH account contributions are made with post-tax dollars, meaning that you’ve already paid federal taxes for that income. Because of this, the money in a ROTH account is never taxed again – however there’s always an outside chance that Congress might change the rules, though most consider this outcome unlikely. For ROTH IRAs, there are additional income limits – once you make a certain amount annually, ROTH IRA contributions aren’t allowed. (I have some suggestions for those who are above or near the income limits). For ROTH 401k and other employer sponsored plans, these income limits don’t exist.


It’s worth noting that there are two main ways to have a retirement account, through employer sponsored plans (401k, 403b, 457b/f) or opened yourself (IRA – Individual Retirement Account). The big difference between an IRA and employer sponsored retirement accounts are the contribution limits. An IRA is limited to $6,000 annually while an employee sponsored plan allows up to $19,500 of employee contributions annually. There is a big advantage to having access to an employer sponsored plan for the higher contribution limits. However, this is only valuable for those that make enough to comfortably contribute the full amount to their employer plans. The ideal situation is to make the max contribution to both your IRA and employer plan, to maximize tax advantages.


I Want to Start Investing, Which Retirement Account Should I Pick?

Though very much an individual decision based on your circumstances, I would generally suggest that if you are in your residency, fellowship, or early in your career, choose the ROTH option to maximize your tax-free account growth over decades. It’s the option that I choose for my 401k and I make contributions to The Surgeon’s and my (the SurgeonSpouse) ROTH IRA annually.


For some real numbers to understand the potential saving and investing opportunity, here’s how much The Surgeon and me can potentially save in tax-advantaged accounts annually:

Surgeon’s ROTH IRA$6,000
SurgeonSpouse’s ROTH IRA$6,000
SurgeonSpouse’s ROTH 401k + Employer Match ($6k)$25,500
Total in retirement accounts for tax year 2020:$37,500

If we take that $37,500 and invest it in the market for the next 30 years, (even if we don’t add any more to the initial investment) and account for an 7% annual increase in the market (not including inflation), this will be worth $285,000. If you make consistent annual max contributions (of $37,500 in this scenario), this could potentially grow to $3.8 million in 30 years.


Given the recent tax cuts and overall tax environment in the US currently, many speculate that this is the lowest tax rates we might see in our lifetimes (as a card carrying millennial here). If we’re basing our investment decisions on this theory, then it’s definitely a wise choice to pay taxes now and invest in a ROTH account.

What’s the TL,DR?

In summary, choose ROTH accounts (if available) early in your career to put away as much money as you can post-tax into tax advantaged retirement accounts. If you don’t earn enough to comfortably make maximum contributions to all accounts (don’t worry! life is a marathon, not a sprint), contribute what you can to your ROTH IRA first.

I know I just threw a ton of information at you – what questions do you have? Leave a note about your retirement account investing strategies in the comments! Whether you’re just starting out, or a seasoned investor, taxes are always an important component to consider when saving and investing.

-SurgeonJourney

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