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Roth IRA vs. Traditional IRA: Which is the Best Deal?
Wednesday, 24th October 2007 (by J.D.)This article is about Choices, Investing, Retirement
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I’m often asked, “Which is best, a Roth IRA or a traditional IRA?” There’s no one right answer.
Which option you choose depends on your goals, and it depends on what you think your income will be like in the future. In theory, there’s no difference between the eventual returns. In practice, there are a variety of factors that can affect your decision, of which tax rates are perhaps the most notable.
Walter Updegrave at CNNMoney — one of my favorite money experts — recently answered this very question:
The tax rates you face prior to and at the time you withdraw your money can also determine whether a traditional IRA or Roth is a better deal.
Generally, if you expect to be in a lower tax bracket at retirement than you were when you made the contribution, then the traditional IRA is the better deal since you’re effectively avoiding tax on your contribution and earnings when the tax rate is higher and paying it later when the rate is lower.
If you expect to be in a higher bracket when you withdraw the money, then Roth is the better choice because you’re paying tax at a lower rate and avoiding tax when the rate would be higher.
And if you expect to stay in the same bracket, the Roth is the better choice because of its inherent advantage of effectively sheltering more money. As a practical matter, however, we can’t always know whether we’ll be in a higher, lower or the same tax bracket in the future.
Ultimately, Updegrave believes that everyone should consider putting at least some money in a Roth IRA. “Even if it turns out in retrospect that the Roth wasn’t the best deal,” he writes, “having access to a pot of tax-free cash can still give you peace of mind and a bit of maneuvering room in retirement.”
For more information about individual retirement accounts:
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The GRS Introduction to Roth IRAs series Part 0: How compound returns favor the young Part 1: What is a Roth IRA and why should you care? Part 2: How to start a Roth IRA (and where to do it) Part 3: Which investments are best for a Roth IRA? Part 4: Questions and answers about Roth IRAs |
October 21st-27th is National Save for Retirement Week in the United States.
[CNNMoney: Ask the expert: The best retirement deal]
23 Responses to “Roth IRA vs. Traditional IRA: Which is the Best Deal?”
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October 24th, 2007 at 2:29 pm
I’m assuming you’re comparing a Deductible Traditional IRA to a Roth IRA. I always exceeded the limit for a deductible IRA. So, faced with a choice between a non-deductible IRA and a Roth IRA, I figured I might as well go for the Roth IRA because it’s after-tax money either way. Of course, I’ve gotten to the point now where I’m almost completely phased out of the Roth IRA too but this is a different problem.
October 24th, 2007 at 2:33 pm
what’s the youngest you can do a ROTH? Could one set up one for a child? (not a concern for me, but something i’ve always wondered).
2nd) I can’t imagine being in a lower tax bracket when i’m 59.5 or older, so boy am i putting what i can into a Roth.
(first up to my match in my 401(k))
October 24th, 2007 at 3:17 pm
Allen,
There’s no minimum age to contribute to an IRA, but you have to have income to do it (and I think the contribution cannot exceed income). So your child needs a job to contribute.
October 24th, 2007 at 3:55 pm
A person of any age can contribute to a Roth IRA as long as they are earning compensation. Compensation is usually defined as income from work. If your teenager is working, they can open and contribute to a Roth IRA. Their maximum contribution can not exceed their annual income, up to $4,000. Another attractive quality to a Roth is you can make penalty-free withdrawals from a Roth for first-time homebuyers or educational exepenses! Visit your local credit union today!
October 24th, 2007 at 4:34 pm
allen: Roth’s can only have ‘earned income’ as contributions, so I’d guess that a child cannot have one set up until they’re old enough to earn income. I’ve not seen many places that will allow people under 18 to set one up.
That said, I think they’re pretty handy investing tools. Nothing like tax-free to ease the mind
October 24th, 2007 at 4:42 pm
Speaking of retirement vehicles, U.S.News had an article about where you should be with your savings at various ages. Comes in handy to see where you should be with your retirement savings. An IRA is just another way to help you get there.
http://www.usnews.com/usnews/biztech/articles/070810/10roth401k.age.htm
October 24th, 2007 at 4:57 pm
Not knowing what my tax liability will be in retirement (it may be higher at times and it may be lower at times), I like the idea of having options when it comes time to take some money out. Ideally, I will be able to choose between tax-free, ordinary income, and long-term capital gains based on the tax environment at that time.
Allen, there is no age limit, but there must be earned income. So if a child earns some money (odd jobs, acting, selling lemonade, etc.) that child can have a Roth IRA.
Regarding deductibility, there is no such thing as a “deductible IRA” or a “non-deductible IRA.” Deductibility applies to the contribution. Whether contributions were deductible, non-deductible, or a combination of each, it’s just an IRA. If you do make non-deductible contributions, you must keep a record of it to avoid being taxed again on those same dollars.
October 24th, 2007 at 5:29 pm
I had heard that regardless of your tax rate in retirement, if your time frame is long the Roth makes more sense because the withdrawls are tax-free and with enough time you’re talking about A LOT of tax-free income.
October 24th, 2007 at 5:49 pm
It is difficult to predict what tax rate one will face in retirement. Tax rates might increase significantly above current rates to fund entitlement programs for the boomers. I think it is a good idea to invest some money in Roth IRA’s as a way to diversify tax risks.
October 25th, 2007 at 5:39 am
Can a married couple start two Roth IRAs?
According to this, http://en.wikipedia.org/wiki/Roth_IRA#Eligibility:_Income_limits
* Single filers: Up to $99,000 (to qualify for a full contribution); $99,000-$114,000 (to be eligible for a partial contribution)
* Joint filers: Up to $156,000 (to qualify for a full contribution); $156,000-$166,000 (to be eligible for a partial contribution)
* Married filing separately (if the couple lived together for any part of the year): $0 (to qualify for a full contribution); $0-$10,000 (to be eligible for a partial contribution).
I’m not sure how to interpret that last part…Does that limit apply to _both_ spouses? Or, can one spouse do the “single” IRA, and the other the married-filing-separately way?
Is there any clever way/loophole around this?
October 25th, 2007 at 7:11 am
Does the 59.5 age only apply to the Roth, or to a traditional as well? Because that would be another factor if you could potentially tap your fund a few years early.
Second question: I see a lot of advice on these sites that advocate having both. Doesn’t Dave Ramsey even say to (after paying down debt) “first fully fund your traditional IRA, then your Roth, THEN a 529, etc”? Is the general consensus then to strive towards both, or am I reading that wrong?
October 25th, 2007 at 7:31 am
The deciding factor was the required minimum distributions (RMD) at age 70 1/2.
I just don’t want to have to worry about paying penalties and/or taxes etc if I don’t withdraw enough money.
I want the flexability to withdraw varying amounts each year without the hassle of being taxed on that money or regulated.
Less regulation for me please. Thank you.
October 25th, 2007 at 1:43 pm
I do not have a Roth IRA. This is because that the Roth is new enough that existing tax treaties with other countries (notably, Canada) do not respect the tax-free growth nature of the Roth. In that case, if you leave the US, the foreign country taxes you on the gains as they accrue.
Contrast this with a 401k or a traditional IRA, which are sheltered by treaty and the foreign country allows you to contribute pre-tax dollars and to let the account grow tax-free until it is time to retire.
It all depends where you want to retire, if you are going to retire outside of the USA a Roth might not be for you.
October 25th, 2007 at 2:55 pm
I have a traditional deductible IRA because my company doesn’t have a 401k plan. Since I don’t get the tax benefits of the 401k, I make up for part of that with the traditional IRA.
October 25th, 2007 at 3:13 pm
Elliott - married couples either file a joint return together or each spouse files a return married filing separately. The only exception to this is where the person is “Considered Unmarried.” Considered unmarried taxpayers have the option to file under Head of Household status if they meet ALL 5 of the following requirements:
1) Lived apart from the spouse for the last 6 months of the year
2) Didn’t file a joint return with their spouse
3) Paid over 50% of housing costs
4) Provided the main home for their child, stepchild or foster child for more than 6 months
5) Claims the qualifying child as a dependent.
I am convinced that as the pot of untaxed earnings grow and as our government looks for creative ways to stea…er um generate more revenue, the promise not to tax earnings on Roths will be forgotten.
Our elected representatives once promised not to tax Social Security benefits and they repeated that promise for many years. Now they are taxed up to 85%.
I still believe that a Roth is a good idea, I am not going to be shocked when the hammer falls though.
October 25th, 2007 at 4:56 pm
Just to be clear: yes, both members of a married couple can have IRAs. In fact, this is true even if one person is not working (the only exception to the rule that you must earn money in order to make an IRA contribution).
You either file a tax return as single, married filing jointly, or married filing separately. So there’s no way for one member of a married couple to be “single” and another to file “married-filing-separately”; you’d both have to file married-filing-separately. Which you wouldn’t want to do, if you want to make a Roth IRA contribution, because the income limit is only $10,000!
And the income limit for married-filing-jointly is the adjusted gross income (AGI) from your tax return, so yes, it include’s both spouse’s income.
October 26th, 2007 at 11:20 am
I disagree that these are theorectically the same even with the right income limits and tax rates staying the same. Traditional lets you build up from 5K or whatever and than gets taxed - if it doubles over 10 years, you get 10K less taxes - maybe 7K. Roth lets you build up from a taxed 5K (say you stared with 6.5K) and then gets it out tax free, so you get 10K out. Roth is working using a higher amount of money.
October 26th, 2007 at 12:24 pm
I have a theory about my ROTH. This country seems to be financing it’s government on a Chinese credit card. In theory that would have to be paid back one day. It makes me assume that taxes will only get higher over time the way they always have.
October 26th, 2007 at 5:40 pm
I have a question about Roth vs. Traditional IRAs. Is there a general rule of thumb as to what age is more appropriate for one or the other. (Not a hard and fast rule, of course, nothing will apply to everyone– but a general trend/sense). I know that Roth generally makes sense for young investors. But at what point does a young investor become not so young and the benefits go in the other direction? (I’m 33, my husband is 40). Thanks!
November 5th, 2007 at 7:31 pm
All of these “Roth v. Regular” articles focus on the internal tax question: “What will MY tax situation look like?” Almost all of the articles I’ve read fail to address the external issue of taxation: “What will tax rates, in general, look like when I retire?”
Given the HUGE deficit we face as a nation in the US, and the growing Social Security (not to mention Medicare) nsolvency, it would be reasonable to assume that ALL tax rates will be higher a few decades from now.
Check out my blog post on the Roth 401k at http://physicianfamily.com/blog/2007/10/09/roth-401k-for-physician-family/
January 24th, 2008 at 12:41 pm
Can you have a Traditional IRA AND a Roth Ira?
January 24th, 2008 at 1:07 pm
@June:
As i understand it, Yes. The RothIRA is a special beast, while the traditinoal IRA you still pay taxes on.
January 28th, 2008 at 2:48 pm
You can and SHOULD have both a traditional 401(k) and a Roth IRA. It will give you the most flexibility when it comes time to retire.