Roth IRA vs. Traditional IRA: Who has the upper hand?
July 12th, 2006One of the most frequently asked retirement planning questions a financial advisor receives is whether one should invest in a Traditional IRA or Roth IRA. I'm here to shed some light on the issue and hopefully provide a simplified explanation to help you with your decision.
Let's start with some basics about each type:
Traditional IRA. With the Traditional IRA you receive a tax deduction for your yearly contributions. Then your account grows with no yearly tax consequences. At the end of the road when you get ready to retire and start withdrawing funds then you have to pay taxes on whatever you pull out at your then prevailing tax rate.
Roth IRA. With the Roth IRA you DO NOT get any tax deduction for your contributions each year. You are making contributions with after-tax dollars. Then your account grows with no yearly tax consequences just like the Traditional IRA. When you start withdrawing funds from the Roth you pay NO TAXES. This is because you paid them on the money when you put it into the account.
In order to illustrate which account would be better from a purely tax related perspective I created the following chart. To compare apples to apples it is necessary to "tax" the Roth participant before their money goes in and then "tax" the Traditional participant when it comes out. So you will see a contribution of $4000/yr for the Traditional holder and a contribution reduced by the tax bracket for the Roth holder. For simplicity we will say they both take a 100% distribution when they remove the funds. This will allow us to show the tax effects on the Traditional withdrawals. When all that is said and done we'll compare the future values to see where we stand. Note: I have ignored the fact that contribution limits will increase and that older individuals can make "catch-up" contributions. Neither of those things matters for this comparison.
In the first comparison notice that the Now and Then tax brackets are the same. Then notice that the future values of the accounts after all taxes are the same. What does that tell you? If you expect that your tax bracket in the future will be the same as it is now then from this perspective you should be indifferent to which account you choose.
In the next two comparisons you'll see that 1) if you expect your future tax bracket to be higher than it is today then it is wiser to choose the Roth and 2) if you expect your future tax bracket to be lower than it is today then it is wiser to choose the Traditional. This is intuitively simple to grasp. You want to take the biggest tax break when you can get it.
Now, those comparisons are from a purely mathematical standpoint. There are some other things to consider before making a decision that may or may not sway you one way or another.
Required Minimum Distributions. The IRS definitely wants its money at some point. That's why, if you have a Traditional IRA, you are required to start taking distributions by age 70 ½. There are no such requirements for Roths. You can keep the money in there until you die if you wish.
Withdrawal of Contributions. Since Roth contributions are made on an after-tax basis then you can withdraw them anytime without penalty or tax. Not so for Traditional contributions. If you withdraw them you will be subject to regular tax AND a 10% penalty for early withdrawal.
Contribution Phase-outs. There are no income limits on Traditional IRA participants. Anyone can contribute to one (assuming they meet a minimum income requirement - usually the amount of the allowable contribution). There are phase out amounts for Roth contributions so that people making above a certain amount cannot contribute to one. In 2005 that amount was $160k for Married filers. Note: there is a phase-out limit for the deductibility of the Tradtional contributions even though you can still make them.
Those are some of the more important differences. There are several others that, to me, do not having a meaningful impact on which account type to choose.
My other "gut" instinct is to never believe tax rates will go down in the future. All other things being equal I am much more comfortable choosing the Roth and paying my taxes now than hoping I will be in a lower tax bracket in the future. It is very possible that you could be in the 31% bracket now and choose the Traditional because you think you will be in the 25% or lower bracket in the future. Then what happens if tax rates increase and you suddenly find yourself in a bracket at higher than 31%? It will cost you more of your retirement savings than you had planned.
There are lots of factors to consider when choosing which type of IRA to use. In fact, you can have both types if you want (though you are still held to the total contributions limit). Your decision will primarily depend on your perception of where you will stand from a tax bracket perspective in the future relative to the present. For me, personally, it is hard to consider anything other than the Roth. Whether or not the government changes tax rates - I plan to be in a higher tax bracket regardless :-)
"All over the place, from the popular culture to the propaganda system, there is constant pressure to make people feel that they are helpless, that the only role they can have is to ratify decisions and to consume."
-Noam Chomsky
Disclaimer: this post is for informational purposes ONLY. Please read the disclaimer before even thinking about relying on me to make a financial decision!
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Using a Self-Directed IRA for Retirement
The Evil, Wicked Indirect Rollover to a New Qualified Retirement Plan
Buying Real Estate Inside a Self-Directed IRA
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