You will often hear about traditional vs. Roth IRAs and 401(k)s. In both cases, your contributed money grows tax-free, so the chief difference between the two is when the money is taxed. In the case of a traditional account, you take an income tax break when you contribute the money and are taxed when you take distributions from the account. The Roth is the reverse – you pay income tax on the money when you contribute it, but the distributions are tax-free. The main question to ask is whether you believe your income tax rate is currently higher or lower than it will be when you take the distributions. While this answer cannot be predicted perfectly because tax rates are subject to the political process, many graduate students are sacrificing income in the short-term for long-term income potential, so it is likely that their incomes and tax rates will jump after grad school and increase with time. Therefore, the Roth seems to be the better choice for most graduate students and young people in general. Even the most tax-break-enthusiastic professionals will tell people to contribute to Roth IRAs when they are in the 15% tax bracket or lower.
The other noteworthy differences between the Roth and traditional options are:
- there are income limits for contributions to Roth IRAs for high earners (contributions start being phased out with a modified AGI above $114,000 for single filers and $181,000 for married filing jointly)
- you must start taking required minimum distributions from a traditional IRA by April 1 of the year after the year you turn 70.5, whereas there are no required minimum distributions from a Roth IRA
- you can withdraw Roth IRA contributions at any time without penalty (but not earnings)
- you can withdraw Roth earnings without penalty in certain situations such as for qualified educational expenses or a first-time home purchase
You should also consider tax diversification. If you are likely to have a higher-paying job in the future and plan to contribute to a traditional 401(k) or similar, you can diversify your tax situation by contributing to a Roth IRA now. That way, in retirement, you will have more flexibility with your distributions, paying tax on some of your income but getting some income tax-free.
Further Reading: Roth Vs. Traditional IRA: Which Is Right For You?; Traditional vs. Roth IRA: Some Unconventional Wisdom on Which is Better for Young Investors; Roth IRA Basics, In a Question & Answer Format; Roth IRA vs. Traditional IRA: The Complete Guide for Wise Investors
Join Our Phinancially Distinct Community
Receive 1-2 emails per week to help you take the next step with your finances.
[…] so using a Roth made total sense. When I speak to current grad students, I advocate using a Roth IRA for retirement savings. But at some point, doesn’t a traditional IRA or 401(k) start to make […]