How to Choose Between a Traditional and Roth IRA
How are your prognostication skills? Do you have a direct connection to the spiritual world or an uncanny ability to predict the future? Someone with these skills and an individualistic drive, and perhaps an advance edition of Gray’s Sports Alamanac, could ensure the financial stability of his or her future.
The rest of us without supernatural powers and without help from a time-traveling friend can only make financial decisions affecting the future on assumptions and best guesses. When it comes to choosing between the two flavors of IRAs, Traditional or Roth, that’s the best we can do.
Looking at my balance sheet, I’ve had IRAs all over the place. I didn’t start one until I was 26 years old, and I wish I had started earlier. Motivational speakers say that you can find a way to invest regardless of your income, even if it’s just a tiny portion. Out of college, I wouldn’t have ignored such advice as my initial salary at a non-profit did not even pay for my commute to work. (I could have moved closer to work, which I eventually did, but then rent costs would have hurt me just as bad; I could have shared a house with a multitude of roommates I didn’t know, but I drew the line there. There’s always an excuse to make, but there’s also a line.)
Since then, I’ve chosen mostly Roth IRAs, though I’ve ended up with Traditional IRAs after changing jobs from each employer to the next. And while I worked on my own, I invested in Traditional IRAs.
The IRA (Individual Retirement Agreement or Account) would be one of the fundamental retirement vehicles available in the United States. It is designed to encourage people to think about the future by providing tax incentives for investing or saving. Social Security, a system designed to assist an aging society, can’t on its own keep those who are too old to work out of poverty. The IRA encourages some personal responsibility.
An IRA can contain just about any type of investment. You can use it for risk-free savings, particularly in the form of certificates of deposit, or you can invest in individual stocks, ETFs, and mutual funds. You can even find opportunities to use your IRA to invest in hard assets like real estate and precious metals.
Traditional IRAs offer savers and investors a tax deduction today, with Roth IRAs push that tax advantage until retirement, when you can withdraw your principal and earnings tax-free. The first question in this decision does not require future assumptions.
Is your income under the tax-deductibility limit? This year, your ability to take advantage of the tax deduction begins to phase out once your modified adjusted gross income reaches $58,000 ($90,000 if you’re married) and completely disappears at a level of $68,000 ($110,000 if you’re married). If your income is above these limits, you can contribute to a Traditional IRA, but you won’t receive the full tax deduction.
Are you allowed to contribute to a Roth IRA? There is another income limitation. Roth IRAs are only available to people earning under a specific amount. Single filers can contribute the full $5,000 to a Roth IRA if their income is below $110,000 ($173,000 for married filing jointly). The maximum investment phases out until income reaches $125,000 ($183,000 for married filing jointly).
Will your tax rate be higher when you’re in retirement? Ever since the regulation that allowed for Roth IRAs was enacted, financial professionals began encouraging young workers to enroll. At the start of a career, a young employee could likely be at the lowest income level of his or her life. They could also be in the lowest tax bracket they’ll ever see. A tax deduction on $6,000 of income in the lowest tax bracket is not as worthwhile as a deduction on $5,000 of income in the highest tax bracket. If you expect your tax rate to increase, pay tax on the $5,000 directed to your Roth IRA today in order to withdraw your principal and earnings tax free when you retire.
There are many assumptions built in to the above reasoning as well as variables that might change. Congress may decide to change the rules for Roth IRAs, making withdrawals in retirement taxable. That could defeat the purpose of forgoing the Traditional IRA deduction today. If you presume you won’t be in a higher tax bracket in retirement, you may be wrong, as some economists believe tax rates will need to be much higher in the future in order to support society’s needs.
Is there a possibility you might need to use your investment soon? With a Roth IRA, you can withdraw your contributions before retirement without paying a penalty in some circumstances. With a Traditional IRA, you’ll need to pay tax on your withdrawals. This could come in handy if you don’t have an emergency fund (you should have an emergency fund) or if your cash becomes depleted for some reason.
Will you live until retirement? If you love high-risk, extreme activities, perhaps you won’t need money in retirement. In fact, the farther you are from typical retirement age — the younger you are — the more likely there is a chance of your retirement being very different from what Americans have known as retirement over the last couple of decades. You may need to work longer, though saving today for retirement can partially offset that need. You may never want to retire, working on something you enjoy until the day you die. It’s hard to say what life will look like 30, 20, or even ten years from now.
Don’t let this decision stop you from investing. The best thing to do is open an IRA as soon as possible if you haven’t already. To generalize, because sometimes that’s easier than actually thinking, if you’re young, investing in a Roth IRA; if you’re older and have established retirement assets already, a Traditional IRA may be the better choice. Work with a company like Fidelity, Vanguard, or TIAA-Cref (avoiding their annuities) that lets you open an IRA immediately even without a sum of money ready to invest. Some companies allow you to start with a small amount as long as you set up a recurring investment.
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Article comments
I have a Roth IRA because I love that it’s a tax free investment vehicle because taxes are going to increase in the future and I plan to work for another 35 years before retirement.
Deciding whether to invest in a Roth or traditional IRA is fairly simple. If you expect your income to increase over the coming years go with the Roth otherwise go with the 401k or traditional IRA in that order. A Roth conversion depends on a number of factors so it is wise to use a calculator to see if it makes sense.
I’m young so I am investing in Roth vehicles now. As I get older and hopefully I move up in the marginal tax brackets I’ll start using traditional accounts and then take some from each in retirement to manage my tax rate. That’s my plan as I see it now but it is likely to change over the next 40 years…
I like the Roth. I figure you have more options when younger, and may not when old age sets in. And, I figure the tax rates will only increase, not decrease. I look at it like your younger self is giving a gift to your older self.
If only the older self was able to use the Roth IRA as a vehicle to give a gift to a child.
Since you are looking at predicting the future let me add a little known strategy that you may not be aware of. I’m retired, but because I had a 401(k) and an income level that exceeded ROTH IRA limits I didn’t start contributing to my ROTH until AFTER I retired – that’s right – after retirement – and without working. The IRS gives you the ability to “convert” tradition IRA assets to a ROTH IRA. All you have to do is pay the taxes. Being retired, my income level is in the 15% tax bracket and after deductions and exemptions there is headroom between my taxable income and the ceiling of the 15% bracket. By converting the saving to a ROTH I have to pay 15% tax on it, but – and it’s a big but – If I were to leave it alone, when I turned 70 and 1/2 the Required Minimum Distribution would push me well into the 25% tax bracket. Pay it now @ 15% or later @ 25%. It was an easy decision. One caveat: Although I can withdraw any of my contributions now without paying taxes the ROTH “account” must be 5 years old before the earnings are completely tax-free.
That’s a clever strategy. I like it!
It wasn’t original thought, so I can’t take credit … I read about it in an article by a Professor from Baylor University and published by Kiplinger. But it’s working so I like it too!
I’m retired, too, so this is valuable. Back in the day, I figured I can manage my income when I’m retired. Since we don’t live a lavish lifestyle, the income we draw will usually be in the lower tax bracket. That, and my marginal tax rate at the time were enough to sway me to the traditional IRA, and not the Roth.
But this good information. Is there a limit on how much you can roll from trad to Roth? Or can you do it all in one fell swoop?
You can do it at one time but the taxes might be hard to swallow and you might lose the advantage of the lower tax bracket. What I do is convert just enough to bring me to the ceiling of my current tax bracket. Turbo-Tax usually comes out early enough that I do a trail return in December that gives me a good estimate of what I can convert. In the past two years we’ve managed to just move shares and pay the taxes from non-deferred accounts which increases the benefit of conversion. My estimate right now is that when (or if) I live long enough I’ll push my marginal tax rate increase out about 4 years past 70 and 1/2. Since I started this in 2008 that would equate to nearly $30,000 in tax avoidance.
I am hedging my bet and investing in both. It fits in my philosphy of multiple income streams.
Exactly! I have Roth and Traditional IRAs. I was thinking of converting my traditional and realized it was silly to pay the taxes on it. I asset allocate, not only with funds, but between the various types of investment accounts. You never know what the government might have in store for us in the future.
One additional point is that many employers do not offer Roth 401(k)’s. So, if you’re investing in both a 401(k) and an IRA, use one traditional and one Roth. Employer matches go in the traditional 401(k), which is good to keep in mind.
Couple points I’d add :
– Everyone gets a certain amount of tax free income via the standard deduction and exemption. So a married couple in their 60’s would have about $20k of tax free income. For this reason you should start with a traditional IRA to take advantage of that tax free income at retirement time. Unless you have other forms of taxable income in retirement then it makes sense to have a sizable amount in traditional IRAs to use the deduction/exemption.
– If you happen to currently have 0 tax liability and an effective 0% tax rate than the Roth is the nobrainer choice. Us the Roth to lock in the 0% tax today and get $0 tax in retirement.
Thanks I didn’t know that Traditional IRA’s had a tax benefit that phased out depending on income.
Since predicting the future is rather futile, I believe in a balanced approach, so I have both traditional and Roth IRAs. If forced by circumstances to choose between making a tax-deductible contribution to a traditional IRA or a contribution to a Roth, my personal preference is to take my tax benefit NOW when I’m certain of both the magnitude of the benefit and that I’ll get it, so I’d choose the tax-deductible traditional contribution.