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

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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).

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10 years ago

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


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.

10 years ago

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.

10 years ago

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.

10 years ago

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.

Paul Smudski
Paul Smudski
10 years ago

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… Read more »

Daniel Packer
10 years ago

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… Read more »

10 years ago

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… Read more »

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

by JoeTaxpayer time to read: 3 min
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