You have come to the conclusion that you and you alone are responsible for your retirement. Good for you. You have decided to use an IRA (Individual Retirement Arrangement) as the vehicle to accomplish your goals. Good for you again. Now you are struggling with whether you should use the Traditional or the Roth IRA. Hopefully, this article will help you with this decision.
While both plans are considered tax advantaged, they differ in how the taxes are handled. A Traditional IRA gives the contributor an IRS deduction for his annual contribution to the plan, but the retiree is required to pay income taxes when he accesses the money. With a Roth IRA, the contributor gets no tax deduction at the time of the contribution but pays no taxes when drawing the money out.
Because of these different tax treatments, conventional wisdom is that if you think you will be in a lower tax bracket upon retirement, you should choose the traditional IRA. Why? Because you would have received a deduction at a higher rate when contributing and paid the taxes back at a lower rate when receiving the money.
Roth IRA Vs. Traditional IRA Examined
To prove this point, let’s compare two people who make exactly the same salary and are both in a 20% tax bracket. Jill chooses to contribute $300 a month to a Roth IRA. Jack chooses to contribute an equitable amount to a Traditional IRA. This equitable amount will be $375 a month. How did I get $375? Because Jack is using a Traditional IRA, he will claim a 20% deduction of his contribution, which is $75. $375 – $75 = $300, which is Jill’s contribution. Are you with me so far? Another way to view this is that both make the same salary and, with this illustration, both will receive the same net pay after their contributions.
Assuming that both continue their contributions for 30 years and are able to get a 10% annual rate of return for the 30 year period, Jill would have a nest egg of $678,146 while Jack’s nest egg would be $847,683. Who did better? It depends on the tax rate Jack would have to pay when drawing his money down from his traditional IRA. If that tax rate is still 20%, we have a tie because $847,683 less 20% taxes equals $678,146…the exact same amount of Jill’s nest egg. Obviously, if Jack could get by paying less than 20% upon retirement, the traditional was the better plan; if he pays more than 20%, the Roth would have been the better choice.
So how does this example help you with your decision?
photo credit: m0bile
If you KNOW that you will be in a higher bracket, you should go with the Roth. If you KNOW that you will be in a lower tax bracket upon retirement, you should probably consider the Traditional. I said “probably” because there are other advantages of the Roth that could sway you that direction even if you do end up in a lower bracket. What are these differences?
- Contributions to a Roth can be withdrawn tax free at any time. The Traditional would require you to not only pay the taxes but also a penalty. Note: you shouldn’t tap your retirement savings for any reason except for an extreme emergency. But should that extreme emergency happen, the Roth is clearly advantageous. The Roth IRA withdrawal rules can be tricky, so make sure you understand all the consequences.
- You can withdraw up to $10,000 in earnings tax free from your Roth in order to acquire a principal residence for a first time buyer. Again, not something I recommend, but this is an option with the Roth and not the Traditional.
- Unlike the Traditional, the Roth does not require minimum distributions at age 70 1/2. Why? Your Uncle Sam has given tax deductions for that Traditional IRA nest egg and, if you haven’t started paying him back by age 70 1/2, he will force you to. Because any withdrawals from the Roth are tax free, your Uncle has no incentive to force you to take them.
- The Roth covers you for future tax increases. With our National Debt spiralling upward, tax rates are more likely to increase than decrease by the time you retire. With the Roth, you have already paid your taxes, so future increases will not affect you.
These are not the only differences between the plans, and you would do well to talk to a Certified Financial Planner or Estate Planning professional for further details and how they apply to your situation. What do I think? I think that you should always choose the Roth unless you are absolutely certain that your tax rate will be lower when you retire.