Early savers are met with very complicated decisions on their way from their working years to retirement. These complications usually appear where investing and taxation intersect. Not surprisingly, the choice between a traditional IRA or Roth IRA is one such complication.
Let’s start first by discussing taxation, which is the the most complicated part of traditional and Roth IRAs.
- A traditional IRA is tax-deferred. When you contribute to a traditional IRA you do so with pre-tax dollars. Upon withdrawal, taxes are deducted at your income tax rate at that point in the future.
- A Roth IRA is tax exempt. Contributions made in a Roth IRA are made with post-tax dollars. Any amount withdrawn at retirement is not taxed because taxes were already paid on the money that went into the account.
Assuming no difference in tax rates at the time of deposit or withdrawal, there is no difference between a Roth or traditional IRA as far as taxes are concerned.
If you invest $10,000 in a traditional IRA and it grows to $100,000, you’ll pay $25,000 in taxes if you withdraw the money at a 25% tax rate. If you invest $7,500 of post-tax dollars in a Roth IRA and it grows at the same pace, you’ll have $75,000 of tax-exempt retirement savings.
It’s taxes that matter
While there are a few small differences between a Roth and traditional IRA, the only one that will really matter in the long run is whether or not you’re making smart tax moves.
The decision tree is as follows:
- You should invest in a traditional IRA if you think your income tax rate at retirement will be lower than it is right now. This will be true for a surprising number of people. High income earners today will not be high income earners at retirement. So, it is quite possible that their incomes at retirement will be lower, and thus their tax rates will also be lower.
- You should invest in a Roth IRA if you think your income tax rate will be higher at retirement than it is right now. This will be true for the very youngest of savers. A working professional just out of college who makes $40,000 per year will probably make more per year in retirement (assuming they save aggressively and enjoy rapid salary growth) and will thus be in a higher tax bracket. As such, it makes sense to pay the taxes today rather than pay them later in a higher income bracket. As someone in this group ages, it would make sense to go traditional, rather than Roth.
This is a decision not worthy of over-thinking. There are some who say that the government will raise tax rates and thus a Roth is a better retirement account. Likewise, there are others who say that the Roth is equally exposed to tax changes, since the implementation of some kind of federal sales tax would double tax Roth balances and do no harm to traditional IRA investors.
Unfortunately, no one can know what the future holds for taxation. It seems most likely that tax rates will rise slightly for everyone, but most for high income earners. No matter what happens in tax rates from A to B, a saver’s tax changes from moving into a new income bracket will likely be greater than any increase in taxes over the period from saving to retirement.
For the obsessive planner unwilling to tolerate some uncertainty, consider tax diversification. Set up an IRA oppositely than a 401k. If you have a traditional 401k, set up a Roth IRA. The diversification can at least give you the knowledge that you’ve at least hedged your bets with any tax law changes.