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 Any amount withdrawn at retirement is not taxed because taxes were already paid on the money that went into the account.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.
We are hedged with Roth IRA and traditional 401Ks. We think it’s a good balance for what we hope to accomplish early retirement wise as well.
Another thing to consider when evaluating Roth vs. Traditional IRA is what type of investments you want to house in each. If you have investments with more risk, but you think may have higher returns (i.e. aiming to outperform a benchmark index) than maybe housing that additional growth in a Roth makes more sense because you won’t be taxed at the end.
You bring up a great point about tax diversification, it’s one that many people completely overlook. I think it can be nearly as vital as being properly diversified with your investments.
I say have a diversified portfolio of tax strategies. I contribute to a Roth while I am young and will move to a traditional as I get older probably. As tax outlooks become more certain I will be able to make better decisions.
Your point about overthinking should be emphasized. The benefits of contributing to an IRA at all is exponentially better than deciding between traditional and Roth.
Thanks for the article! I prefer to use a Roth, it goes along with the whole “sacrifice now for greater returns later” philosophy of investing.
There are secondary reasons for young people to invest in a Roth IRA. You can use it as a down payment for a house. I believe you can withdraw just your contributions for buying a home tax free.
When I opened my Roth, I was making $18,000 per year. It was really a no-brainer.
As I earn more income, I should be putting more in the traditional IRA and 401(k) accounts as opposed to Roth. But I love me some Roth, and as long as I’m in the 25% bracket (married), it probably doesn’t make a difference, but in my mind, I’d rather pay the taxes now. It makes calculating retirement income easier down the road (because I don’t need to adjust for taxes).
It would be the smartest for teens around the age of 18 to start investing in roth IRA’s. I’m sure you’ll be in a much higher tax bracket once you stop working at your local restaurant or grocery store. The problem is that most younger people are too irresponsible to start investing now. They need to educate teens about investing for retirement, so they don’t have to learn from their mistakes. I would definitely use a Roth IRA at this point in my life.
Rob – my 14 year old will deposit to her Roth for the 4th year this summer. Her goal is to graduate college with a retirement account over $50K.
Remember, the choice when saving is based on your marginal rate, but withdrawals, if this is you main retirement income, are your average rate. With no pension or other income, you have a standard deduction, exemption, and then a 10% bracket, etc.
Best rule of thumb I can offer if no details about person are known is to use Roth when in the 10/15% brackets, and slide into pretax when at 25% or higher.