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
Roth Traditional Roth Traditional Roth Traditional
Pre-tax Investment $5,000 $5,000 $5,000 $5,000 $5,000 $5,000
Current Tax Rate 25% 25% 25% 25% 25% 25%
Initial Investment $3,750 $5,000 $3,750 $5,000 $3,750 $5,000
Annual Rate of Return 8% 8% 8% 8% 8% 8%
Time (years)  30  30  30  30  30  30
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%
Taxes Owed $0 $12,578 $0 $15,094 $0 $10,063
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.

Income Limits: While there are income limits on IRA contributions, the Backdoor Roth IRA is open to those of all income levels.

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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  • Gregory Morill

    Its up to you with of the two IRA meet the income requirements. This two IRA play a part in your retirement plans and once you’ve figured out which will work better for you. I found this video on youtube it may help you

  • Gregory Morill

    Its up to you If you meet the income requirements. This two IRA play a part in your retirement plans and once you’ve figured out which will work better for you. I found this video on youtube you can check it out

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  • Nick Hepler

    The logic on this is flawed. If one is investing in an IRA (Traditional or Roth) they would have the same initial investment because the money they have to invest has already been taxed. This assumes that the person investing in the Traditional IRA gets an instant tax rebate to invest, but in reality the reduced tax liability (of $1,250) is not realized until the individual files their tax return. Therefore, if two people invest the same amount ($5,000), the individual with the Roth will end up with less tax liability in the end because the return far exceeds the initial investment. The individual with the Traditional IRA will have more disposable income at the end of the year they invested, but the Roth investor will have much more at retirement.

  • NickB

    I like what Nick said. Honestly, investing in an IRA is a great thing. The issue today is that many people would like to invest in things other than the stock market but don’t realize that they can with their retirement accounts. If you are wanting to invest in things like gold, real estate or even private businesses you can do it with a self directed IRA. Why not invest in the things you know and love? Investing in the stock market or bonds may not be your thing or you may want to invest in something a bit safer or more your style. You can do it with a self directed IRA. Investing in your retirement the way you want really is possible.

  • Pat Thomasson

    Thinking about retiring early? The Roth could provide an option for retirement income before you reach the magic age of 59.5 and have access to your 401(k) because you can withdraw your contributions with no penalty.

  • BJToepper

    This example is correct, but doesn’t show the more usual case of a saver contributing the full amount into a Roth. As I write current contribution limits are $5,500, though in this example they were at $5,000. At a 25 percent tax rate, a saver would have to earn over $6,000 — and pay taxes — to contribute the full $5,000 amount, making the effective contribution limit into a Roth higher than in a traditional IRA. The extra savings over the years can have a startling effect on total value.