Traditional or Roth - Which is Better?

Here's the REALLY short answer: It depends.

Less short answer: If you expect your tax rate to be higher when you use the funds, you should probably contribute to a Roth. But if you expect your tax rate to be lower in the future, you should contribute to a Traditional IRA.

If you’re satisfied with that, great. If not, keep reading for more detail in the LONG answer.

Brief refresher on how retirement accounts work:

1. Retirement accounts are NOT investments. They’re just accounts that have different tax characteristics, so you can invest just like you’d be able to in any other account, with some restrictions.

2. The investments within the accounts are not taxed year-by-year. Typically, only withdrawals may be taxable.

3. You need earned income (income from working) to contribute to any type of retirement account.

4. Traditional IRAs are “pre-tax.”

   1. When you make a contribution, you get a deduction in that year. If you’re in the 22% tax bracket, a $1,000 contribution saves you $220 in federal taxes.

   2. When you withdraw funds, you pay taxes on the withdrawal.

      1. If you’re over 59.5, there’s no penalty, so that same $1,000 if withdrawn in a 22% tax bracket will cost $220 in federal taxes.

      2. If you’re under 59.5, you’ll pay the federal taxes PLUS a 10% penalty, unless an exception applies.

5. Roth IRAs are “tax-free.”

   1. When you make a contribution, you don’t get any deduction in that year. No tax savings.

   2. When you withdraw funds, they’re usually tax-free.

      1. If you’re over 59.5 and the Roth has been open for 5 years, withdrawals are tax-free.

      2. If you’re under 59.5 and/or the Roth has been open for less than 5 years, you can still withdraw your contributions tax-free, but any earnings are subject to taxes PLUS a 10% penalty if you’re under 59.5.

So what are some of the benefits of a Roth IRA as opposed to a Traditional IRA?

1. You don’t have to worry about what future tax rates will be.

2. You can access contributions at any time, tax-free.

3. It’s very likely that you’ll have other sources of taxable income in retirement that will fill up lower tax brackets (Social Security, Traditional IRA balance, pension, annuity).

4. They provide less tax headaches for non-spouse beneficiaries when you pass away.

5. No required minimum distributions.

Some benefits of Traditional IRAs over Roths?

1. You may be able to save more since you’re getting a tax break.

2. Traditional IRAs paired with a charitable intent can be a way to eliminate taxes instead of just deferring them. Once you’re over 70.5, you can make Qualified Charitable Distributions to a charity of your choice completely tax free.

3. You’ll likely be able to do Roth conversions (move Traditional IRA dollars to your Roth and pay taxes on them at that time) in future years when you have a lower income/tax rate.

4. It’s possible that you’ll pay a lower tax rate on your withdrawals than your savings on your contributions.

The Age Factor

I often (but not always) recommend that younger people (<35) contribute to Roth IRAs regardless of their current tax bracket.

Why?

There are a couple of reasons.

First, one of the best ways to limit lifetime taxes is to fill the lowest tax brackets every year. Because of how long money has to compound when you start investing at a young age, it doesn’t take as much to fill those low brackets in retirement.

Next, your peak earning years tend to be in your mid-40s. That’s when you likely want to be making pre-tax contributions, but if you already have a bunch of pre-tax dollars, you’re probably setting yourself up for more tax in retirement.

Also, the government debt thing is kind of an issue. The US has continued to grow debt in relation to GDP. At some point, it’s likely that the government will do something to try to make the problem less bad. The two levers they have are raising taxes and cutting spending. It’s not out of the realm of possibilities that tax rates will be higher in the future, and it seems less likely that they’ll be lower. However, that is purely speculation, and should be considered with less weight than the other factors.

Finally, Roth IRAs provide more flexibility since you can access contributions with no tax at any time. At younger ages, flexibility is worth quite a bit. It’s hard to quantify, but that doesn’t mean it should be ignored.

Conclusion

Traditional IRAs and Roth IRAs both have their place, and the best type of account for you to contribute to is a highly personal decision. A good financial planner will help you to determine the best amounts to save into different types of accounts (certainly not limited to pre-tax or Roth IRAs). This is just one of the many benefits of working with a financial planner.

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As always, keep in mind that you don't have to go it alone. I’m Austin Preece, a financial planner in Eau Claire, Wisconsin, and I work virtually with people across the US. Check out my website to see what it's like to work with me and reach out if you have any questions.

If you found this post helpful, help spread the word! Share with friends and family that you think may benefit as well. But remember, this is solely for educational purposes - it's not advice.