The question comes up pretty often, and I’ve dealt with it in general with my recommended “Order of Contributions”, that we discussed briefly during last month’s newsletter. The order is as follows:
1. Contribute enough to your employer-provided retirement plan to get the company matching funds.
2. Maximize your contribution to a Roth IRA.
3. Continue increasing your contribution to your employer-provided plan up to the annual maximum.
Beyond those three items, you may want to consider college savings accounts, tax-efficient mutual funds in a taxable account, or a low-cost annuity, among other choices.
But the question I was referring to is this: Which is better, a Roth IRA or a Traditional IRA?
The answer, as usual, is a fully-qualified “It depends”. I’ll try to explain the most important factors.
If you were to consider the two types of accounts side-by-side, at first glance you’d think that it doesn’t make any difference which one I contribute to – especially if I assume that the tax rate will be the same in retirement (or distribution phase) as it was before retirement (or accumulation phase). This is because you’re paying the same tax on the distribution of the Traditional IRA after the investment period, simply delayed, that you would pay on the Roth contribution, only this part is paid up-front.
Clear as mud, right? Let’s look at the following table to illustrate. I have purposely not included any increases in value, as we’ll get to that a bit later. In the example, we’re using a 20% ordinary income tax rate.
Each year we had $1,250 available to contribute to either a Traditional or a Roth. We had to pay tax on the Roth contribution each year, but we were able to make the whole contribution, tax-deducted, on our Traditional account.
What happens when we throw in growth in the account? The following table reflects the next step in our analysis, with each account growing at 10% per year, and the values are as of the end of the year:
If you subtract the tax from the Traditional balance, you come up with the same number as the Roth account, since there is no tax on the Roth account at distribution. So, although you pay more in taxes, you had more contributions to your account, so it all comes out in the wash.
So far, I’m not yet convinced that I should use a Roth instead of a Traditional IRA. Let’s make another change to our table, by assuming that the tax rate in distribution is 25%, and that we remain at a 20% rate during accumulation. The following results come from that change:
As you can see, this results in a nearly $1,100 increase in taxes at distribution, making the Roth IRA the preferred option. Conversely, if the ordinary income tax rate is lower in distribution, the Traditional IRA is a better option.
There are some other factors that we could consider and run calculations on, but for the most part we’ve covered the important bases. If you’d like to see some more research and discuss the pros and cons of the types of IRAs, please give me a call. I have many wonderful spreadsheets to share, if you’d like to see them.
By strictly running the numbers, the Roth IRA is preferred when the income tax rate is higher in retirement, and it’s at least as good as the Traditional IRA if the rates remain the same. If the numbers were the only differences between the two accounts, this is not a strong argument for the Roth, because you’re just making a gamble as to what will happen with tax rates in the future.
Thankfully, there are more factors to bear on the decision. In the September edition of this newsletter, I pointed out three very good reasons to choose a Roth IRA over a Traditional (deductible) IRA (see below).
With those factors in mind, and given that I have a generally pessimistic view of tax rate futures in the US, the Roth IRA is the better choice in nearly all situations.
Three Very Good Reasons to Choose The Roth IRA Over the Trad IRA
1. Roth IRA proceeds (when you are eligible to withdraw them, post age 59½) are tax free. That’s right, there is no tax on the contributions you put into the account and no tax on the earnings of the account. You paid tax on the contributions when you earned them, so in actuality there is no additional tax on these monies.
2. There is no Required Minimum Distribution (RMD) rule for the Roth IRA. With the Trad IRA, at age 70½, you must begin withdrawing funds from the account, whether you need them or not. For some folks, this is probably the biggest benefit of all with the Roth IRA.
3. Funds contributed to your Roth IRA may be withdrawn at any time, for any reason, with no tax or penalty. Note that this only applies to annual contributions, not converted funds, and not the earnings on the funds. But the point is that you have access to your contributions as a sort of “emergency fund of last resort”. While this benefit could work against your long-term goals, it may come in handy at some point in the future.
4. (a bonus!) As illustrated, if you believe that ordinary income tax rates will remain the same or increase in the future, the calculations work in favor of the Roth IRA.