Tradition IRA vs Roth IRA: Which One Should You Choose?

Up until about 10 years ago, there was one type of IRA, the traditional IRA which was deducted from your taxable income, grows tax deferred, and upon withdrawal, is taxed at whatever rate you find yourself. Its cousin, the Roth IRA is the mirror image, the money you put in is after tax money, but you never pay tax again on it, at least according to current rules. So the distinction can be summed up as our Uncle Sam saying, “You can pay me now, or pay me later.”

Three Approaches to Minimizing Your Taxes with Tradition IRA and Roth IRA

Now, it’s easy to understand what tax bracket you are in now, or at least where you were on your last year tax return. Take a look at your taxable income toward the end of the return, and take a peek at Fairmark.com, and from that table, you’ll know your rate now. The tough part is to forecast your tax rate at withdrawal. The truth is, unless you are close to retiring, you can’t know, and even if you are, our friends in congress are able to change things just when you think you have your plan in place.

So what’s an investor to do? There are three approaches you can take, each has its advantage.

1. Tax Diversification

The first is Tax Diversification. Mike Piper does a great job discussing this method.

2. Full Pre-Tax Savings (Traditional IRA or 401k)

Next, let’s discuss the concept of going full pre-tax.

How much would you need to save for this to be the ‘wrong’ choice?

Today, a retired couple is in the 15% bracket for taxable income up to (but not over) $67,900. Taxable. They also have a standard deduction of $11,400 as well as their two exemptions, $3,650 each. The grand total is $86,600. To generate this much income, even if you are withdrawing 5% per year (most advisors suggest 4% as the maximum withdrawal each year) it would take over $1.7 million.

Given the current average retiree’s account is nowhere near this number, this strategy actually has some appeal. On your 40 year journey to retirement, the road is rarely without bumps. You can take advantage of periods of unemployment or underemployment to convert some money to a Roth IRA, and pay taxes in the year your bracket drops. If disabled, you can take it out without penalty, using your standard deduction and exemption to have some tax free income.

3. Roth IRA Savings

Last is a bit of a different approach. If you find that you are in the 10% or 15% bracket, more than half of us are, you should choose the Roth IRA path.

Optimize Your Tax Savings By Living In The 15% Bracket

There’s a good chance that by just paying attention to your finances and reading this, you are not average. You are above average in both motivation and intelligence. Thus, the chance that you earn your way right into the 25% bracket and beyond are higher for you than the data suggests. Whether it’s five or ten years from now, or sooner than that, you will find yourself in the 25% bracket. At that point choose pre-tax savings.

When you right at the edge, it can be tricky, using a combination of both Pre-Tax IRA along with Roth to get your taxable income right at the edge of the bracket, so the next dollar of income would be taxed at 25%, but the last was taxed at 15%. You may find that when you buy your first home, the combination of mortgage interest, property tax, and state income tax is enough to put you back in the 15% bracket. Back to a Roth for you.

If you are well within the 15% bracket, you could also use Roth IRA Conversion, where you take some pre-tax IRA money, and pay the tax, turning that money into Roth IRA dollars.

See where I’m going with this? There are a large number of people for whom this is the optimum strategy. This will have you “living in the 15% bracket” and it’s worth the time to understand your tax bracket to get the most benefit from these retirement accounts.

IRA Phase Out Limits

Before we finish this discussion, it’s important to understand the income thresholds that might limit your options. If you are married, the phase out for Traditional IRA contributions is $89,000-$109,000, for Roth, it’s $166,000-$176,000. If you are single, the phase out for Traditional IRA contributions is $55,000-$65,000 for Roth, it’s $105,000-$120,000. So for those who are above the limit to deposit to a traditional, your best choice is to go with the Roth. Above the next phaseout range, where even the Roth is unavailable to you, you can choose to deposit to a IRA, with post tax money and perhaps convert to Roth, if you choose to, starting in 2010*. Take advantage of the options available to you.

* Please note that there is a special Roth IRA conversion event in 2010 (see comments below for clarification).

About the Author

By , on Sep 28, 2009
JoeTaxpayer
JoeTaxpayer is the writer behind JoeTaxpayer.com, a blog where he offers financial commentary for the average Joe. Please visit his blog and subscribe to his RSS feed.

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Leave Your Comment (16 Comments)

  1. Will says:

    Interesting post. Here are some thoughts I had after reading your post. If you just now opening an IRA for retirement I believe there is just 1 choice. A Roth, for the simple fact that your distributions are going to be tax free.

    If there is still money in the account once the opener has passed the ROTH account can be rolled to a new generation and continuing to grow until the new beneficiary needs it, and rolled over for of 3 generations.

    If you open a Self Directed Roth IRA you then have an account that is much more flexible in what it can invest in. Creating a positive monthly cash flow inside a Roth IRA is very powerful for ones retirement.

    I hope everyone that can possibly take advantage of the coming 2010 conversion does do that with all the cash they can. As well as taking advantage of deferring the tax burden over several years. It’s just 3 months away now.

    From talking with people about IRA investing and retirement most folks don’t seem to consider how inflation will affect their nest egg. If you have 1 million today it’s not going to be worth that same amount in 20-40 years. So your really going to need a significant amount more than what you think.

    • JoeTaxpayer says:

      Will – are you on track to have over $2M in retirement accounts? The one choice you cite may only benefit the top 10% of savers or even fewer than that. The tax you pay on that money today can also grow for 40 years and come out at a low rate depending on how well you saved.
      I’m sorry, I think you missed the point of this post.
      Joe

  2. Great post, but I have a question that maybe people will respond to. This year, I graduated college and started working in July. I’ll only be making about $25,000 in 2009, so I’ll clearly be putting it all in a Roth IRA. My question is what I should do come 2010. Making $50,000 a year, does it make sense to put it in a traditional IRA or 401(k)? My gut is to say no, because at age 22, I’m likely to be in a much higher tax bracket later in life. My company does not match 401(k), so right now I have 10% going to a Roth 401(k). Any thoughts would be extremely helpful and I appreciate the comments.

    • JoeTaxpayer says:

      Daniel, I tend to agree with your logic. You are likely to work you way quickly into a higher bracket and it may make more sense to go pre-tax once you’re there.

      • Daniel Packer says:

        Are you saying that because at that point I won’t qualify for a Roth IRA? Or because I’ll be paying 28% in taxes on that money, but when I take out the money I’ll hopefully be paying less than that in taxes? Finally, are you taking into account that taxes will likely increase over the next 40 years?

      • JoeTaxpayer says:

        I say it for a numbers of reasons;

        The chance of you working for 40 years with no break or lower income is slim, even if it’s due to your wife staying how a few months after having a baby. Between the mortgage interest property tax state tax, you can drop back down.

        I understand that taxes may (will?) increase. But consider, retirement accounts skim off the top, at your marginal tax rate. Withdrawals first get to be withdrawn at the zero rate (standard deduction or itemized deductions, plus exemptions) then the 10,15,25% brackets. Single, today, a retiree would need nearly $2M pretax for withdrawals to put him into the 28% bracket.

        If you’re not comfortable choosing between the two, I have no issue with Mike Piper’s advice and simply split the funds. In the 25% bracket, your chance for error is minimal. It’s when I see 33% bracket people with little savings load up on Roth, I wonder.

  3. Paul Smudski says:

    Another consideration for choosing between a Traditional or a Roth IRA has to do with how much you expect to earn in the IRA. Most IRAs are set up with “traditional” brokerages or mutual fund companies which limit your investment options to stock, mutual funds, bonds, or other familier investment types. However, special IRA custodians exist that don’t restrict you to only those investment options. Just about any investment vehicle is legal within your IRA including Real Estate, Notes and Mortgages, or Tax Liens. You can even start a company within an IRA, or invest in a Private Placement LLC that expects to significantly outperform what the general market can do.

    Many of these alternative investment approaches, if you have the specialized knowledge to invest in them, can bring you returns that far exceed what you might get from stocks or mutual funds. For instance, if you assume the investor contributes $5,000 each year for 30 years and earns a consistent rate of return of 9% each year by investing in Mortgages instead of stocks, the IRA would be worth about $748,000 at the end of that 30 years.

    If it’s a Roth IRA, you would pay taxes only on the contribution of $150,000 (30×5,000). And by the time you retire, that expense is already over and done with. With the Traditional IRA, you may have saved the taxes on that $150,000 over that 30 years, but now you’re faced with the tax bill for this huge amount, during your retirement years. Even at only the 15% bracket, the difference can be significant.

    The difference becomes even more stark as you learn how to earn even more per year on your investments in a Self Directed IRA.

    To me the question becomes “On which amount would you rather pay the tax?” The answer to that question becomes increasingly significant the more you use your specialized knowledge of certain investments to earn significantly higher returns in your IRA.

    (The numbers I’m using here are for illustration purposes only and do not reflect any particular investment.)

    • JoeTaxpayer says:

      Paul -
      I’ve re-read your comment, and wonder. Since the same investments are available in a Roth vs Traditional IRA, the decision should be independent of that variable. In other words, whether you plan to invest in a 10 bagger (i.e. an investment bound to return ten times your money) or one that will only double by retirement, the choice to go Roth or Traditional should be based on your current tax rate (known) and your projected assets at retirement (not quite knowable 100%.)

      • Paul Smudski says:

        JoeTaxpayer,

        Sorry it took so long to respond to to your comment. Actually, I agree with your assessment. I have a different perspective though. With the investments that I’m doing, an investor has the opportunity to increase the asset base in his IRA significantly by the time he retires, even if he only has 15-20 years left before age 59 1/2. And there’s no reason to stop investing just because you’ve reached that age.

        I guess if you really boil down what I’m saying to its bare essentials, I am saying at least one of the same things as you. Choosing between a Traditional and a Roth should be based, at least in part, on your projected assets at retirement, understanding that you’re not going to know this for sure. And your projected asset base can only be determined by using expected rates of return.

        My point is this: If you know that you have some specialized knowledge that will allow you to consistently get significantly higher returns on your investments and you use that knowledge for investing in your IRA, you will be much better off over the very long run.

        With the investments that I do, if you have 40 years to use those investments to grow your IRA, your assets could grow well into the millions of dollars. Which would you rather pay tax on, $200,000 ($5,000 x 40) or $2,200,000 (say) that your assets grow to?

        Here an example. If you’re in the highest tax bracket today – 38% – you would pay that marginal rate on your contributions to a Roth IRA each year. Over 40 years, if that stays constant, you would contribute $200,000 and pay $76,000 in taxes on that amount.

        If you use a Traditional IRA and grow the account to $2.2M and then take 4% out each year, your first year’s income would be $88,000. Using today’s marginal tax rates (10%, 15%, 25%) and claiming the standard deduction plus an additional amount (say $6000) that you could deduct, you would pay over $13,800 on a taxable income of $70,600, just in the first year (filing as a Single).

        Now say everything stays constant. You remove $88,000 every year for the next 20 years. That’s over $276,000 that you would pay in taxes in those 20 years versus $76,000 over 40 years. With a Roth, you get to keep every penny of that $276,000.

        It doesn’t stop there. When you die, your IRA gets inherited and your heirs are now stuck with that tax burden each year. I’m don’t know that much about inherited IRAs so I won’t get into that, but with a Roth, even your heirs don’t have to pay taxes (in most cases).

        From my perspective, your projected assets when you retire is a large consideration.

  4. Kyle says:

    My family is currently using my 401k as our main method of retirement saving. My wife’s business does not do 401k matching and their options aren’t that great so we are looking at setting up a Roth IRA for her. We probably won’t meet the income requirements for a traditional IRA so ROTH is probably our best bet. I wish I could say we were maxing them out, I just don’t see how people do that.

  5. Britt says:

    Excellent article!

    Just one point, though… You state:

    “If you are single, the phaseout for Traditional IRA contributions is $55,000-$65, for Roth, it’s $101,000-$116,000.”

    Those are actually 2008 phase out figures for the Roth IRA. For 2009, Roth IRA contributions phase out between $105,000-$120,000.

  6. Craig says:

    I started my Roth IRA this past year and will max it out. Being young and very little knowledge about retirement accounts, I have learned this is the best option for me, especially since I don’t have any 401K option through work.

  7. Dangerman says:

    “So for those who are above the traditional limits, your only choice is Roth.”

    WRONG!

    You can do a non-deductible Traditional IRA, and then convert it to a Roth next year. Or, even if you don’t convert, it may be more efficient to use a non-deductible Traditional IRA to hold your highly taxable assets (i.e. bonds) if you’re keeping them in there for a long time.

    • JoeTaxpayer says:

      Dangerman, you are correct, given the different thresholds, you first lose the traditional IRA option, at that point, it only makes sense to choose Roth. Once Roth income threshold is exceeded, you’re only choice is the non-deductible IRA. I should have been more clear when writing that thought.

      Thank you for reading this, and helping me clarify.
      Joe

    • Jason says:

      Great post and explanations.

      Dangerman’s right, the non-deductible T.IRA and then a Roth conversion has become a fairly popular strategy with the affluent, but reporting takes a little extra work.

      It’ll be interesting to see what legislation changes come down the road in relation to tax rates and Roth IRA rules etc given the state of the US debt load and need for a tax hike.

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