Which is Better: a Roth IRA or a Traditional IRA?

[Sean]

Every week, I receive more questions about Individual Retirement Accounts (which are more correctly known as “Individual Retirement Arrangements”, or IRAs). These are great tools to help the average American save for retirement.

But one question comes up over and over: which is better, a Roth IRA or a traditional IRA? The answer is: “It depends.” There are several subtle differences between the two that affect those near (or in) retirement. (Investopedia has a good summary of the differences.) For most Get Rich Slowly readers, the four most important considerations are these:

1. Contribution limits for Roth IRAs and Traditional IRAs are identical. In 2008, you may contribute $5,000 a year to your account. If you are 50 or older, you may contribute an additional $1,000.
2. Roth IRAs have income limits; traditional IRAs do not. For the 2008 tax year, single filers must make less than $101,000 to qualify for a full Roth IRA contribution. Joint filers must earn less than $159,000. (This limit is actually tied to your Modified Adjusted Gross Income.)
3. Both types of IRA are tax-advantaged, but in different ways. You’re usually able to fund a traditional IRA with pre-tax dollars — you pay taxes when you withdraw the money. (If you or your spouse has a retirement plan through an employer, the deductibility of your traditional IRA contributions may be subject to income limits.) The money you put into a Roth IRA has already been taxed, and will grow tax-free, therefore you’re able to withdraw it tax-free.
4. You must take yearly distributions from a traditional IRA (and pay taxes) when you are over 70-1/2 years old. There’s no such reqired minimum distribution with a Roth.

So if you qualify for both, which one is best? In general, the rule of thumb is that you should choose a Roth IRA if you suspect your retirement tax rate will be equal to (or greater than) your current tax rate. If you think your tax rate will decrease during retirement, then you should choose a traditional IRA.

If you want more than just a rule of thumb, check out the Roth IRA vs. Traditional IRA calculator from CCH Incorporated. (Which appears to have originated at Dinkytown.)

I like this calculator because it makes all of its assumptions explicit. The main page defines all the parameters the tool uses: expected rate of return, current tax rate, retirement tax rate, etc. If you want to know more about the behind-the-scenes calculations, click the “view report” button to get a thorough report.

While this calculator is fun to play with, it doesn’t solve the fundamental problem: nobody knows what tax rates will be like in the future. If you make very little now, you can guess your tax rate will probably be higher in retirement. If you make a lot, your tax rate is likely to be lower. But what about the rest of us?

I asked Dylan Ross of Swan Financial Planning for his advice:

"Because many people will have tax deferred savings from other sources anyway, it usually makes sense to go with the Roth when you have the choice.
Most people will not be withdrawing their entire IRA in a single tax year. It’s entirely possible that some years will have higher tax rates than present and some years will be lower. This is why I think it makes sense to try to have tax-free (Roth) and tax-deferred savings, so I can have options in the future. If I want to save some of my tax-free when I’m retired because tax rates are at a low and I suspect will eventually rise, I’ll pull from my traditional IRA. If tax rates are super high, I’ll tap the Roth.
I’m an advocate of diversifying the tax treatment of my retirement savings, but in the end, when you have a choice, putting it all in the Roth is usually the better move. (And if you can afford to make the maximum contributions, the Roth always wins.)"

So which is better? It depends. Your circumstances determine which makes the most sense. If the choice is not clear to you, you should probably consult a qualified professional, such as an accountant or a certified financial planner.

If you’re more interested in 401(k)s than IRAs, JLP at All Financial Matters recently shared a comparison between the Roth 401(k) and a traditional 401(k).

Source: http://www.getrichslowly.org/blog/20...aditional-ira/

[Bob]

a roth IRA is a much better choice IMO because you can choose how much you put in and you don't have to worry about taxes. if you are making above the threshold for a roth IRA you don't exactly need one as you should be saving enough as it is.


401k is generally not the best idea out there although once our economy hits total rock bottom it wouldn't be a bad idea because you can't really lose money on the investment. it can only go up

[Sean]

If your younger than I would recommend a Roth IRA. As far as taxes go, you still have to worry.

For example, let's say you made $30,000 during the year, and you put $2,000 of it into an IRA. You would pay income tax on only $28,000. Additionally, your deposit will grow free of tax through the years. When you finally withdraw the money for your retirement -- after age 59 1/2 -- then, and only then, will the money be taxed as income at your ordinary income tax rate.

The tax breaks for a Roth IRA are different. Unlike a contribution to a traditional IRA, a Roth IRA contribution is never deductible. Taking the above example, you'd still be taxed on $30,000 even though you had put the same $2,000 into a Roth IRA. However, when you withdraw the money from a Roth IRA, none of it -- and that includes the earnings -- will be taxed, assuming that the Roth IRA has been open for at least five tax-years and you are older than age 59 1/2. That's right -- you get off scot-free with the booty. All you have to do is to wait until you can withdraw it penalty-free. Again, that's after age 59 1/2, and as long as it's been in there for at least five years.

Check out this calculator, which shows the difference in earnings between a Traditional IRA and a Roth IRA. You'll be surprised!!

[Bob]

i know. on the plus side, you still have deductibles. you pay the taxes on the IRA now so you don't have to pay them when you take the money out.

When people cash out their IRAs it's because they need to use the money. the last thing you want is to get taxed