The first thing that you must know in the traditional IRA vs. Roth IRA debate is that there isn’t one answer that is right for everyone. You must take into account your particular situation to determine which investment vehicle is right for you.
However, there are many ways to help you decide which one you should use.
Let’s take a look at how we can decide whether a traditional IRA or a Roth IRA is better. But first, let’s figure out the major difference between the two types of IRAs.
Traditional IRA vs. Roth IRA: The differences
There are quite a few differences between the two IRAs. However, the main difference between the two is their treatment of taxes. Should you pay taxes now or when you retire? And does it really even matter?
Tax treatment
With a traditional IRA, you will pay taxes when you take money out of the IRA (when you retire). However, you will not pay any taxes when you first put money into the IRA.
A Roth IRA is the complete opposite of a traditional. Instead of paying taxes when you take money out, you pay taxes when you first put money into a Roth. When you take money out of a Roth IRA, you do not have to pay any taxes on the distributions.
Withdrawals
One good thing about Roth IRAs is that you are allowed to withdraw the contributions to the Roth before age 59.5. This can be good if you are looking to retire before this age and need the money.
Roth IRAs also do not have any required minimum distributions that you must take at age 70.5. This allows you to keep your money in the Roth and continue to watch it grow until you, or your heirs, need it.
Traditional IRA vs. Roth IRA: The Ultimate Showdown
So it seems like the Roth IRA may be slightly better for many people because of the withdrawal options. However, taxes will be the deciding factor between the two investment vehicles.
Generally speaking, if you expect your taxes to be higher in retirement than they are now, then you should invest in a Roth IRA. However, if your taxes will be higher now than in retirement, than you should invest in a traditional IRA.
When I talk about taxes here, I am talking about your marginal (or highest) tax rate. For instance, if your top tax bracket is 10% now, but you expect it to be 22% during retirement, then you should definitely invest in a Roth IRA.
Let’s take a look at a couple of case studies to determine which investment vehicle a couple should invest in.
Case Study #1: Earning $100,000 in taxable income now and $50,000 in retirement
Assumed Taxable Income Now: $100,000
- Marginal Tax Rate: 22%
Assumed Taxable Income in Retirement: $50,000
- Marginal Tax Rate: 12%
Since this couple wants to lower their taxable income now, it makes sense for them to invest in a traditional IRA. This will save them the marginal tax rate now, which is higher than their rate in retirement.
VERDICT: Invest in a traditional IRA
CASE STUDY #2: Earning $50,000 in taxable income now and $100,000 in retirement
Assumed Taxable Income Now: $50,000
- Marginal Tax Rate: 12%
Assumed Taxable Income in Retirement: $100,000
- Marginal Tax Rate: 22%
Since this couple wants to lower their taxable income in retirement, it makes sense for them to invest in a Roth IRA instead of a traditional IRA.
VERDICT: Invest in a Roth IRA
CASE STUDY #3: Earning $50,000 in taxable income now and $50,000 in retirement
Case studies 1 and 2 were pretty easy to figure out. Generally, taxes help you determine whether you should invest in a traditional or a Roth IRA. However, when the expected marginal tax rate is the same now and in retirement, it can be more difficult to determine which investment vehicle to choose.
When figuring out what to invest in, there are a couple of things that may help to sway your decision towards a Roth IRA.
- No required minimum distributions: As mentioned before, a traditional IRA requires you to take money out of it at age 70.5. A Roth IRA has no such restrictions.
- Easy withdrawal of contributions: The Roth IRA allows you to withdraw your contributions before age 59.5. The traditional IRA does not (although you can sometimes get around this restriction.)
- Tax diversification: Since you may already invest in tax-deferred investments like a 401(k) or a 403(b) at work, the Roth IRA can be a good way to diversify your taxes. Investing in both a 401(k) and a Roth IRA will allow you to take advantage of tax benefits now with the 401(k) / 403(b) as well as later with the Roth IRA.
- General psychology: To get the complete advantage of a traditional IRA, you must not only invest in it, but you also must invest the tax savings that you receive. For instance, if you invest $6,000 in a traditional IRA and $6,000 in a Roth, you will end up with more money in a Roth. This is because the investment in the traditional IRA is with before tax dollars, which are not as valuable as the after tax dollars in the Roth. The only way to have the same amount of money in a traditional IRA and a Roth is to also invest the tax savings that you receive each year from the traditional IRA. Many people won’t do this.
VERDICT: Usually invest in a Roth IRA
One additional consideration
A final consideration to think about is future taxes. What do you think taxes are going to do when you retire? If you are retiring in a couple of years, then it probably makes sense that taxes will be the same in retirement as they are now.
However … what if you are planning on retiring in 20 or 30 years?
According to the Tax Policy Center, the total tax revenue in the United States is 26% of gross domestic product (GDP). In other developed countries, the average total tax revenue is 33% of GDP.
Since the United States has a smaller tax revenue than most other developed countries, our tax rates may increase in the future.
Again, this makes the Roth IRA a bit more favorable than the traditional IRA.
What I do
Currently, my wife and I both max out our Roth IRAs each year instead of investing in traditional IRAs.
Originally, we did this because Dave Ramsey told us that investing in Roth IRAs is better than investing in traditional IRAs. Although I enjoy Dave Ramsey’s teachings, he doesn’t really talk about comparing your taxes in retirement with your taxes now. He just says that a Roth IRA is always better (which is definitely not true). Again, it depends on your situation!
However, after comparing the two IRAs (and not just listening to Dave Ramsey), we are still going to invest in Roth IRA’s. Here’s why:
- We expect our income in retirement to be similar to our income now. This is because my wife and I should both receive a small pension (even if we retire early) and we will receive distributions from our investment accounts.
- We also invest in a 403(b) and a 457(b). Since these are before tax accounts, investing in a Roth IRA allows us to have tax diversification in retirement.
- We expect taxes to increase. Although it doesn’t feel like it when I look at my paycheck, federal income taxes are pretty low right now. Since the United States has a large national debt and underfunded programs such as social security, I expect that taxes will go up in the future.
No matter what, determining where to invest your money is a very important decision. Let us know in the comments which investment vehicle that you use.
And, as always, thanks for reading!
~Nathan
Let’s keep living a great life … with the help of money. So what’s next?
- You can travel for free by using rewards credit cards.
- You can get motivated and get out of debt.
- You can check out the next post or the previous post and continue to learn.
But no matter what you decide to do, let’s leave the ordinary behind and take action today!
