Which is Better: a Roth IRA or a Traditional IRA?
Tuesday, 18th March 2008 (by J.D.)This article is about Money Hacks, Retirement, Tools
Every week, I receive more questions about Individual Retirement Accounts (which are more correctly known as “Individual Retirement Arrangements”, or IRAs). These are great tools to help the average American save for retirement. Most of the time I’m able to route people to one of my previous articles on the subject:
|
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 |
But one question comes up over and over: which is better, a Roth IRA or a traditional IRA? The answer is: “It depends.” There are several subtle differences between the two that affect those near (or in) retirement. (Investopedia has a good summary of the differences.) For most Get Rich Slowly readers, the four most important considerations are these:
- Contribution limits for Roth IRAs and Traditional IRAs are identical. In 2008, you may contribute $5,000 a year to your account. If you are 50 or older, you may contribute an additional $1,000.
- Roth IRAs have income limits; traditional IRAs do not. For the 2008 tax year, single filers must make less than $101,000 to qualify for a full Roth IRA contribution. Joint filers must earn less than $159,000. (This limit is actually tied to your Modified Adjusted Gross Income.)
- Both types of IRA are tax-advantaged, but in different ways. You’re usually able to fund a traditional IRA with pre-tax dollars — you pay taxes when you withdraw the money. (If you or your spouse has a retirement plan through an employer, the deductibility of your traditional IRA contributions may be subject to income limits.) The money you put into a Roth IRA has already been taxed, and will grow tax-free, therefore you’re able to withdraw it tax-free.
- You must take yearly distributions from a traditional IRA (and pay taxes) when you are over 70-1/2 years old. There’s no such reqired minimum distribution with a Roth.
So if you qualify for both, which one is best? In general, the rule of thumb is that you should choose a Roth IRA if you suspect your retirement tax rate will be equal to (or greater than) your current tax rate. If you think your tax rate will decrease during retirement, then you should choose a traditional IRA.
If you want more than just a rule of thumb, check out the Roth IRA vs. Traditional IRA calculator from CCH Incorporated. (Which appears to have originated at Dinkytown.)
I like this calculator because it makes all of its assumptions explicit. The main page defines all the parameters the tool uses: expected rate of return, current tax rate, retirement tax rate, etc. If you want to know more about the behind-the-scenes calculations, click the “view report” button to get a thorough report.
While this calculator is fun to play with, it doesn’t solve the fundamental problem: nobody knows what tax rates will be like in the future. If you make very little now, you can guess your tax rate will probably be higher in retirement. If you make a lot, your tax rate is likely to be lower. But what about the rest of us?
I asked Dylan Ross of Swan Financial Planning for his advice:
Because many people will have tax deferred savings from other sources anyway, it usually makes sense to go with the Roth when you have the choice.
Most people will not be withdrawing their entire IRA in a single tax year. It’s entirely possible that some years will have higher tax rates than present and some years will be lower. This is why I think it makes sense to try to have tax-free (Roth) and tax-deferred savings, so I can have options in the future. If I want to save some of my tax-free when I’m retired because tax rates are at a low and I suspect will eventually rise, I’ll pull from my traditional IRA. If tax rates are super high, I’ll tap the Roth.
I’m an advocate of diversifying the tax treatment of my retirement savings, but in the end, when you have a choice, putting it all in the Roth is usually the better move. (And if you can afford to make the maximum contributions, the Roth always wins.)
So which is better? It depends. Your circumstances determine which makes the most sense. If the choice is not clear to you, you should probably consult a qualified professional, such as an accountant or a certified financial planner.
If you’re more interested in 401(k)s than IRAs, JLP at All Financial Matters recently shared a comparison between the Roth 401(k) and a traditional 401(k).
I am looking forward to reading this series - thanks for posting. I converted a Traditional IRA account to a Roth IRA way back when, but I won’t be making any more contributions to it. I don’t trust Congress to keep their tax-free promise, so I will be making only tax-deductible IRA contributions (that is, ones to a Traditional IRA) in the future. That way, I get the tax break today.
I don’t qualify for the Roth IRA but I do have a Roth 401k option at work. I have no idea what tax bracket I’ll be in when I retire but I’m investing some of my 401k monies into the Roth option because I want options when I retire.
The advice I have been prone to give on this subject is to base this decision on how much you have in retirement savings now and how far away you are from retirement. If you have a lot of retirement savings or are far away from retirement the Roth is the best bet since you are likely to be in a higher tax bracket when you retire. If the opposite is true then you are likely to be in a lower tax bracket when you retire and should go with the traditional.
I believe the Roth IRA should be a priority for the individual investor. I agree with my friend Dylan;)in that respect. I understand the concept of tax diversification, but if you contribute to a traditional 401k or your employer makes a traditional contribution match on your behalf, then a Roth IRA is definitely the way to go.
The classic argument is no one knows what your future tax bracket will be, well how about controlling it yourself and taking the debate off the table completely, how’s 0% for a future tax bracket, that you have total control over. Not to mention the estate planning benefits and no (RMD’s)required minimum distributions the Roth affords investors.
Also, I think the likelihood of the Roth rules being rescinded and all pre-existing contributions losing their tax free status are slim to none; pre-existing contributions will be grand fathered. I think anyone that chooses to believe that (and this keeps them from making Roth contributions) is doing more harm than good.
I agree that tax diversification makes a lot of sense; therefore a Roth may be a good companion when you have large amounts in a Defined Contribution employer sponsored retirement plan, such as a 401(k). However if you don’t have a 401, because your employer has not set one up or because you are self employed, a traditional fully deductible IRA might be a good option because of the tax reduction you get today. If you are self employed and would like to contribute more, consider setting up your own retirement plan.
How does the conversation about investing in either Roth or Trad. IRA change with a tanking economy?
I think it’s important to have both an IRA and a Roth IRA for tax diversification purposes. Taxes are pretty low now, so paying them now and withdrawing tax free later is a good thing. If they go even lower later on then you don’t get 100% screwed. And if they go way up, at least some of your money with come out tax free.
@grimsaburger
Conversations about any investment choices should never change based on current market conditions. If anything, now is a good time to make your contributions for the year. I dumped $3k into my Roth last week for 2008. The rest will go in with regular payments.
We are at historical lows for taxes, we can only assume the rate will be higher in the future. If we were to move to a fair tax though, I wonder how these types of accounts would be treated.
I’m on the diversify investments and tax rates plan too. 401k and roth ira.
These are all good posts about this old question.
One other advantage for the Roth option is the emotional one. (I heard this on Clark Howard, and it makes sense). When people evaluate their own savings and preparedness for retirement, they tend to mentally ignore the tax liabilities. Therefore, they are more likely to effectively save more in a Roth vs. a Traditional because they won’t feel like they have quite as much.
You sez:
1. Contribution limits for Roth IRAs and Traditional IRAs are identical.
2. Roth IRAs have income limits; traditional IRAs do not.
I’d just like to point out:
#1: Since the contributions to a roth IRA are after tax and the traditional IRA are before tax, the limits are not really the same. To put $5000 in a trad-IRA you need to earn $5000. To put $5000 into a Roth IRA you need to earn more like $7000. In effect the Roth IRA has a higher contribution limit. So if you are going to put in close to the limit you should choose the Roth IRA because it has the (effectively) higher limit.
#2: By the same token if you qualify for the Roth now, but you might not in the future when your income goes up, then you probably want to do the Roth now while you can.
The next question that you might want to post on would be “Roth IRA v. 401k, which is better?”
Thanks.
Hey Jeremy - even if you become ineligible to make a Roth IRA contribution in the future, you can always make a non-deductible traditional IRA contribution, at anytime, and convert it to a Roth IRA in 2010 and after, it’s a convenient “back door” into the Roth IRA regardless of future income eligibility.
I am self employed. My accountant and financial advisor are setting up a Simple IRA for me. I can contribute more each year (I believe that it is $12,000), and my company can match. Not sure of all the specifics, since it is not totally in place yet. But from the way this is being explained to me, this is the self-employed/small business answer to the 401k.
@Candice - the max employee contribution for 2008 for the SIMPLE is $10,500. Employers have the option to make an additional elective contribution of 3% dollar for dollar or a non elective contribution - up to 2% of an employee’s pay.
The self-employed/small business answer to the 401K is the Solo 401k, which is designed to give you much of the same flexibility afforded any 401k, except it can only be set up for owners and their spouse.
I think it can be summed up as:
Think about it, the younger you are, the more likely you are to be in a lower tax bracket, and lets face it, taxes will NOT be lowering.
The younger you are, the more likely you should be investing in a ROTH.
I like the general rule that i heard from somewhere:
Fist: Match your Company’s 401(k) (if you have it) donation
Next: Max out your Roth
Third: If you still have the moola to invest, go back to your 401(k) till you can’t do that anymore either
Fourth: If you STILL have money left over [good job!], then look into things like traditional IRA’s.
Boo for being taxed now AND later.
Candice - if you weren’t told about them before, it’s also worth investigating whether a single-person 401k (usually for sole proprietors with no employees) or a SEP-IRA is better for you.
grimsaburger - doesn’t change a thing. Economies of large governments make corrections and we’re experiencing one. Read up on dollar cost averaging theory.
I second Jemery’s point #1. If you are maxing out tax-advantaged accounts, a Roth account lets you effectively squeeze a little more money in. This year I am rolling an old 401(k) into a Roth IRA to get even more money into tax-advantaged status.
Based on my calculations, if you assume that one invests the tax savings in an after tax account, you still come out ahead if your taxe rate goes down, if it only goes down a little. E.g. if you’re in the 25% bracket now, and in the future that goes down to the 20% bracket, you still break even.
One thing that gets overlooked, even if tax rates are the same when you retire, the traditional IRA could be better.
The reason is that you put in you highest marginal tax income. But if your retirement assets supply a significant portion of your retirement income, then parts of them will be taxed at lower rates (because we have a progressive tax system).
That’s not to say the Roth is bad, and most of my savings are Roth assets. But there is a reason the traditional could be better.
One HUGE benefit of the Roth that most people overlook is that the money you put in (not the earnings) can be taken out AT ANY TIME for ANY REASON with NO PENALTIES. Once you put money in a 401k or Traditional IRA it is gone until age 59.5 unless you have special circumstances.
In my opinion, it is foolish to waste an opportunity to contribute to a Roth.
David: why read up on something when I can just ask y’all?
I suspected the answer was exactly what’s been said here, but it seems to be a bigger than average “correction,” so I guess what I was really curious about is whether there is a point at which the economy becomes so weak that you’d be better advised to hold off on an IRA.
@grimsaburger: what about the economy would cause one to be advised to “hold off on an IRA”?
Does anyone know how the income limit for a Roth IRA has increased over the years? I’m “close” to the limit now, and I’m not expecting huge leaps in my income. I’m wondering if the income limit would increase similarly to my salary, or if I’d be better off with a traditional IRA.
I dunno, I suppose I think of the big banks and investment firms as the scaffolding that hold the economy together, and when they start to wobble, I just wonder if there comes a point when investing becomes a good way to lose rather than grow your money.
Now, by the way, is the point at which I become acutely aware of how little I get about macroeconomics.
@grimsaburger: I’m not so sure. Investment firms are simply a conduit one uses to buy an investment (such as a stock). If Fidelity were to go under, I could just use a different broker. Am I missing something?
The economy is held together by small business. Its just the only true metrics avaliable come from publicly(sp?) traded companies.
My local economy is supported by commercial banking, tobacco farming, and biotechnology. But for every employee of a big company (myself included), there is a teacher, a farmer, a small business owner, and a small business employee. The conservative nature of my city allows us to thrive when the market is down.
If you have your finances in order, a recession is your time to thrive. The biggest returns in the market will happen as the market recovers from recession.
Now is the best time to buy a house, a car, start investing, etc…
Isn’t it possible, at least in theory, that stocks across the board could dwindle to the point that using a different broker wouldn’t make a bit of difference? And in that case, it would be a better idea to let money sit in an FDIC-insured savings account at a measly 2%?
Surely this is getting way deep into hypothetical territory, for which I apologize…
@The Weakonomist: yeah - it’s important to remember that most of America is employed by small business. Most companies aren’t the GEs, Microsofts, and Apples of the world - most of them are like where I work, a 20-man employee-owned firm.
@grimsaburger: when stock prices go down, it’s time to snatch ‘em up - they are on sale! If you are in it for the long term, the stock market is where it’s at. If you are in it for the short term, you should avoid the stock market. It sounds like you might have the typical “buy high sell low” mentality - it’s important to break free of that line of thinking in order to be a successful investor.
I’m no kind of investor because I have no Roth yet….
I’m not an alarmist at heart, and I don’t have much if any anxiety about recession since I have a steady income and a firm grip on my personal finances. I just tend to think of investing as a separate endeavor that yanks me out of the real-world economy of small business that I inhabit, and shoves me into the finance part of the economy that does all the roller-coaster-ing. I believe this makes me one of those pesky “risk-averse” individuals.
@grimsaburger: There is nothing fundamentally wrong with being risk-averse, but if you are risk-averse you need to select safe investments, such as deposit accounts, government securities, and short- and medium-term bonds. This will give you less risk, but you have to accept lower return–in some cases, a return that doesn’t even keep up with inflation. That is the trade-off.
What you do NOT want to do no matter how risk-averse you are is wind up in a situation where you try to time the stock market. This is what Daniel says when he talks about the buy high, sell low mentality. If you are going to invest in stocks, you need to go all in and be able to stomach the ups and downs. If you can’t do this, stick to bonds.
Imagine if congress passes the “fair tax bill” which essentially is a consumpton tax on certain goods and services that we purchaseover a predetermined “poverty” level. With a ROTH you have already paid taxes on the money, then you must pay taxes again if you decide to purchase something with that money in retirement.
That said, the “Fair Tax” is unlikely to pass, and if it did, there would certainly be a provision for “Roth” retirement accounts whether they be 401k’s r IRAs.
Personally I invest up the match in my 401k’s, then max out roths for both the wife and I, and then if we still want to save some more will put more in our 401ks.
Ben @ Trees Full of Money
If your employment fluctuates often and you have the flexibility, the best approach can be traditional while working a full year and converting to a Roth when unemployed for much of it, guaranteeing a lower tax rate, but it does mean coming up with additional amounts for taxes during periods of low income. Since you are probably employed more than unemployed, you would only be able to do this with a portion of your savings, 1 year in 5 would suggest 20% traditional 80% Roth.
I max out my 401(k), but my employer does not contribute anything (argh!). My income makes me ineligible to contribute to a Roth. Now I wonder if I should stop the 401(k) and open my own Traditional IRA instead? I honestly never thought about that until reading this post. But I’m not crazy about the investment options in our 401(k) — not many index funds — and if I had my own IRA I could go with someone else.
@Cely:
I would advise against that, becuase with a traditional IRA, you pay taxes NOW, and then AGAIN when you withdraw. @least with a 401(k), you are getting it with pre-tax dollars.
If it will help you feel any better: Think of it as a blessing that you are so well paid that you can’t contribute to a ROTH.
Loving my Roth IRA. I agree that now is a good time to put more in. The number of shares I’m buying of companies that are likely to recover is much higher than it would be if we weren’t going through a correction.
Many people are forgetting about the Roth 401(k). It’s relatively new, and looks to combine the best aspects of the 401(k) and those we associate with the Roth IRA.
@allen[#32]:
I was under the impression that a traditional IRA is tax-deductible. That is, even though you contribute with money from your paycheck after taxes are taken out, when you file your tax forms, you list your contributions to the traditional IRA and get that tax “refunded” to you. Am I wrong?
@fontraid:
http://en.wikipedia.org/wiki/Traditional_IRA#Advantages
Sorry, i was partially wrong. You do get a portion of the money refunded… and if you make little enough money.
to quote the article for those with too little time:
“then a $1,000 benefit ($1,000 reduced tax liability) will be realized for the year. Because qualified distributions are taxed as ordinary income (the taxpayer’s highest rate), the long-term benefits of the traditional IRA are only comparable to those of a Roth IRA (whose qualified distributions are tax free) if the current year tax benefit ($1,000 above) is reinvested.”
from the Wiki article on Tax Brackets in the USA:
for 2007:
25%: from $31,851 to $77,100
So, as long as you make under 77K, then you get a portion of the money refunded.
Question, If I am not eligible for the Roth IRA and am using after tax dollars to invest and expect my taxes to stay the same after retirement would I be better off investing in a regular account over a traditional IRA that will get taxed again?
JD, what did you mean by “Roth IRAs have income limits; traditional IRAs do not”?
Traditional IRA has income limits as far as tax-deductibility is concerned. So if I do not get the tax benefits now and neither in the future, why do I need to go the IRA route. can I not just stick my money on my own in an asset class without the restrictions?
Is it possible to convert Roth contributions to Traditional for a given year? I maxed out my Roth this year, but after doing my taxes realize that I owe a large sum of money to the IRS. I am now looking at the possibility of switching my 2007 contributions to a Traditional (if possible) to get that $4000 deduction.
Thanks for the help!
One advantage I have heard for retirement accounts funded with pre-tax dollars is that the extra money you can contribute to a traditional IRA (because you don’t have to pay taxes, the same amount of income will get you a larger contribution) earns interest for all those years you leave it in there. The magic of compounding works in your favor with the traditional IRA.
Obviously, this assumes that you won’t be maxing out your Roth.
Can anyone comment on this?
[...] JD takes another look at the Roth IRA vs. the Traditional IRA. [...]
There are two things mentioned here that I think are most important:
1) It is always better to go with the Roth IRA if you are contributing the maximum. This is because $5000 in a Roth will bring a better return than $5000 in a traditional IRA and the tax savings ($1250 for the 25% tax bracket) in a taxable account.
The exception is if the deduction changes your eligibility for other tax savings. For instance the tax credit lower income taxpayers get for retirement savings.
Something people have not mentioned is that retirement savings are usually protected in bankruptcy. So while the money in the Roth IRA is protected, the tax savings from a traditional IRA deposited in a taxable savings account is not.
2) You can withdraw the money you put into a Roth account. So you should never put any money into a taxable savings account that you don’t intend to spend within a year until you have maxed out your Roth contribution. A Roth IRA is a perfect place to start building that emergency fund everyone says you should have. If you don’t use it, you have a great start on retirement savings. If you need it, you haven’t lost anything by having it in the Roth instead of a regular savings account.
“The magic of compounding works in your favor with the traditional IRA.”
It does with the Roth as well.
Whether you put $3750 in a Roth and pay $1250 in taxes or the whole $5000 in a traditional IRA should be a wash if your maximum tax bracket is 25% when you deposit and when you withdraw. Remember you will pay taxes on the earnings in the traditional IRA. You won’t pay any taxes on the earnings in the Roth.
Or to make it clearer, if the $3750 in the Roth account doubles in value you will have $7500. The same rate of return on the $5000 in the traditional IRA will give you $10,000, but you will have to pay 25% tax on it. So the net is still $7500.
I agree that the Roth is usually better. I wrote some advice on using IRAs for people who are just starting to think about retirement and don’t have a 401K at:
http://www.zestegg.com/No401K.aspx
The article is called “but I don’t have a 401K, what about me?”
One isn’t necessarily better than the other, they are suited for different scenarios. Understanding the rules of a Traditional IRA can help: http://www.life123.com/article_FullStory/Understanding-Traditional-IRA-Rules_1205353975576.html
I am over 50 years old. I have a Roth IRA and a traditional IRA. Can I contribute $6,000 to EACH IRA in a calendar year?
@mike: closest to an answer i could find in 3 minutes.
http://www.mydollarplan.com/2009-roth-401k-and-roth-ira-limits/
No you can’t max contribute to both in one cal year, got to pick one.
I have a question I can’t solve. My wife and I both max out our ROTH IRA’s. I also have a Simple Plan at work. We can’t afford to max that out, but my wife has a bank account that is solely hers (from her parents inheritence). I also have a brokerage account that is solely mine (from my grandfather) If she were to contribute $6500 to our household so we could max out the Simple IRA, would she get $6500 (as a percentage) of my brokerage or $3250 (as a percentage) This math is wracking my brain