Is it better to contribute to a Roth or Traditional IRA?
Is it better to contribute to a Roth or Traditional IRA? Unfortunately, there is no simple answer.
Both IRAs and 401(k)s let you choose Roth or Traditional (although some companies don’t offer the Roth 401(k) option). Roth means you pay the taxes up front (invest with after-tax income) and then the investment grows tax-free and you get to eventually spend it without ever paying any more taxes on it. Traditional is the opposite – you pay no income tax up front (contributions are tax-deductible), but you pay taxes years from now when you cash out. So which is better?
|Roth vs Traditional Equivalence|
|Same Tax Rate||Increasing Tax Rates||Decreasing Tax Rates|
|Roth = Traditional||Roth > Traditional||Roth < Traditional|
|Current Tax Rate||25%||25%||25%||25%||25%||25%|
|Annual Rate of Return||8%||8%||8%||8%||8%||8%|
|Account value at retirement||$37,735||$50,313||$37,735||$50,313||$37,735||$50,313|
|Future Tax Rate||25%||25%||30%||30%||20%||20%|
|Net at Retirement||$37,735||$37,735||$37,735||$35,219||$37,735||$40,251|
Taxes: Mathematically, Roth and Traditional are equivalent if your tax rate is the same now as it is when you retire. If your tax rate goes up, a Roth would have been preferable, while if you tax rate goes down, a Traditional would have been the better choice. The numbers used above are just one example, but the relationship between tax rates and the choice of Roth or Traditional holds regardless of the assumptions used.
So the question is “Will my tax rate be higher when I retire?” There are a few factors to consider. First, national tax rates are likely to rise over the coming decades for nearly all tax brackets given the high national debt and an aging population that will ultimately mean a declining tax base. Also, as you get older you are likely to advance in your career and earn more money, potentially putting you in a higher tax bracket. On the other hand, you may have a lower income in retirement than during your working career, putting you in a lower bracket than your current one.
It’s a judgment call, but most young people who are at an early stage of their careers should probably choose a Roth account. For older workers nearing retirement and a declining income, a Traditional account may make more sense. Since projecting the future is always uncertain, some people choose the perfectly valid strategy of diversifying their tax exposure by contributing to a combination of Roth and Traditional accounts.
Early Withdrawals: While taxes are the primary consideration in choosing a Roth versus a Traditional account for most people, there are also some minor technical differences between the two account types to be aware of. While it is generally not advisable to withdraw retirement assets early, sometimes life circumstances make this unavoidable. Traditional IRAs charge a hefty 10% federal penalty tax on withdrawals prior to age 59.5 unless an exception applies. Roth IRAs are more flexible, allowing investors to withdraw their contributions penalty-free. However, any earnings on contributions are still subject to the 10% penalty if withdrawn prior to age 59.5. Exceptions include withdrawals of up to $10,000 for first time home purchases, postsecondary educational expenses, substantially equal periodic payments within the IRS guidelines, medical expenses exceeding 7.5% of your adjusted gross income, health insurance premiums after 12 weeks of unemployment, IRS levies, and disability or death of the account holder. Consult the IRS website for more information on qualifying exceptions to the early withdrawal penalty tax.
Required Minimum Distributions: Another difference to consider between Roth and Traditional IRAs are that Traditional IRAs require the account holder to begin taking minimum distributions at age 70.5 while Roth IRAs do not. If you plan to start living off your retirement savings by your 70th birthday, as most people do, then this difference will not affect you. But for those who are fortunate enough to not need their retirement savings right away, a Roth may be preferable since it allows the investor to keep more of his investments in a tax-advantaged account. The lack of required minimum distributions also make Roth IRAs more popular than Traditional IRAs for those who plan to someday bequeath their account.
About the Author
Joanna D. Pratt, CFA is an experienced institutional investor. She holds a bachelor’s degree in economics and certificate in finance from Princeton and an MBA from Stanford.
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