There’s a battle underway in the financial realm. Those taking sides are academics, financial planners, personal finance bloggers and reporters as well as do-it-yourself investors. One side is from the country of Roth and the other, Traditionale (please read that with a French accent). At stake are your opinion and the home of your investment dollars. Who will win—the Roth IRA or the Traditional IRA?
You’ve probably heard or read something similar to this next statement regarding your prospective decision to contribute to a Traditional IRA or a Roth IRA:
If you expect to be in a higher tax bracket in retirement than you are today, contribute to a Roth IRA. If, instead, you are likely to be in a lower tax bracket in retirement, contribute to a Traditional IRA.
By this logic alone, if your tax bracket would never change, there’s virtually no difference between the two. But, like many personal finance one-liners and rules-of-thumb, this one falls woefully short of giving you the whole story.
Which is better—a dollar in a Roth IRA or a dollar in a Traditional IRA? As long as you’re expected to pay taxesi the answer to this question is always – 100% of the time – the dollar in the Roth. This is because the Roth allows you (and your heirs) tax-free growth AND distributions free of taxes. The dollar in the Traditional IRA, on the other hand, is subject to taxation whenever you (or your heirs) remove it. So, if you’re in a 25% tax bracket, your Traditional IRA dollar is actually only worth 75 cents. The higher your tax bracket, the less your Traditional dollar is worth.
So, what’s all that stuff about the Traditional being better if you’re in a higher tax bracket today than you expect to be in retirement? In order for that logic to work, we must assume you take the extra cash on hand, born from your tax deduction specifically associated with your Traditional IRA contribution, and invest it for your future retirement. If you make a $5,000 contribution to a Traditional IRA and you’re in a 25% tax bracket, your deduction should be worth $1,250. In order for the Traditional to benefit you more than a Roth, you must not only to be in a lower tax bracket in retirement, you also have to save that additional $1,250 for retirement. But what do most people do with their tax refund? SPEND IT!
What if you use your refund as a down payment on a car or for a vacation? The Traditional edge is eliminated. What if you didn’t receive a refund at all? Unless you write a check to invest the amount you should have received as a deduction for your Traditional IRA contribution after you write Uncle Sam a check, the Roth wins.
One of the great frustrations in financial planning is that most of the planning is based on assumptions of things we can’t actually control or change—annual income, inflation, market returns and, of course, taxes. So, you can contribute to a Traditional IRAii, calculate the proportionate amount of tax deduction and invest itiii —every year—and then hope the $14 Trillion deficit and a wave of increased entitlement spending somehow doesn’t lead to tax increases OR you can take control of one of those factors and pre-pay your taxes using a Roth IRAiv.
iThat’s where the Turbo Tax prompter would say, “Most people will fall into this category.”
iiBy the way, if your company offers a retirement plan (like a 401k) and you make over $66,000 (in 2010 or 2011) as a single individual or $110,00 as a couple, married and filing jointly, you can’t DEDUCT your contribution anyway!
iiiOf course, if you’ve maxed out your IRA contribution, you also have to invest the tax deduction proceeds somewhere else—likely in an account requiring you to pay taxes on interest, dividends and capital gains as they’re realized.
ivIt’s quite possible that the most attractive features of a Roth don’t have anything to do with taxes. Unlike a Traditional IRA or a 401k, a Roth allows you to take back your contributions at any time, at any age, for any reason without paying taxes or penalties. Furthermore, you’re not required to take Required Minimum Distributions from Roth IRAs—ever. So, unlike a Traditional IRA which forces you to accept fully taxable income after you reach your 70 ½ birthday, your money continues to grow in a Roth unimpeded.