Roth IRA Vs. Traditional IRA: Which is Right for You?
Should you invest in a Roth IRA or a traditional IRA, or for that matter a Roth 401(k) or the traditional 401(k)? So many choices! It’s really just a personal question that depends on your financial situation, including how much your employer will match and your tax rate now and in the future. Other considerations include the tax deduction now and tax deferral that the plans offer.
It sounds like too much time and effort to figure out what’s best, but here’s a quick rule of thumb that you can use to quickly assess the answer to that question: Are your taxes going to be higher or lower when you withdraw the money? If you are younger an earning a lower wage, it may make more sense to go with the Roth, but if you have a higher income, the traditional plan and it’s tax deferral may be better.
Here’s an example of what happens when your taxes are the same now and at retirement; it contrasts the two different types of accounts. In this example, the tax rate is 20%. The savings rate is $5,000 and the interest rate is 8%. For the traditional IRA, taxes are paid when you withdraw funds and for the Roth IRA, taxes are paid up front when you earn the money.
|$ 5,000.00||investment||8%||growth rate|
|Traditional IRA tax bracket 20%||Roth IRA no tax break|
|$5,000 – $1,000 (income tax) = $4,000|
|1||$5,000||$ 400||$4,000||$ 320|
|2||$5,400||$ 432||$4,320||$ 346|
|3||$5,832||$ 467||$4,666||$ 373|
|4||$6,299||$ 504||$5,039||$ 403|
|5||$6,802||$ 544||$5,442||$ 435|
|6||$7,347||$ 588||$5,877||$ 470|
|7||$7,934||$ 635||$6,347||$ 508|
|8||$8,569||$ 686||$6,855||$ 548|
|9||$9,255||$ 740||$7,404||$ 592|
|10||$9,995||$ 800||$7,996||$ 640|
|11||$10,795||$ 864||$8,636||$ 691|
|12||$11,658||$ 933||$9,327||$ 746|
|13||$12,591||$ 1,007||$10,073||$ 806|
|14||$13,598||$ 1,088||$10,878||$ 870|
|15||$14,686||$ 1,175||$11,749||$ 940|
|16||$15,861||$ 1,269||$12,689||$ 1,015|
|17||$17,130||$ 1,370||$13,704||$ 1,096|
|18||$18,500||$ 1,480||$14,800||$ 1,184|
|19||$19,980||$ 1,598||$15,984||$ 1,279|
|20||$21,579||$ 1,726||$17,263||$ 1,381|
|21||$23,305||$ 1,864||$18,644||$ 1,492|
|22||$25,169||$ 2,014||$20,135||$ 1,611|
|23||$27,183||$ 2,175||$21,746||$ 1,740|
|24||$29,357||$ 2,349||$23,486||$ 1,879|
|25||$31,706||$ 2,536||$25,365||$ 2,029|
|Final amount||$ 34,242||$ 6,848||tax||$ 27,394||$ 0|
|Net Total||$ 27,394||$ 27,394|
As you can see, even though the Traditional IRA grew to a larger amount ($34,242 vs $27,394), the tax rates are equal during both periods and at the end you end up with the same amount of money in your pocket. ($27,394) That’s why it’s important to be able to predict your tax rates. How can you do this? Well, one question you need to answer is what your retirement looks like to you and how much will you have. (are you sitting in the chair above or are you struggling to pay your bills?) It’s possible you may be richer in retirement than when you are working if you handle your finances well. In that case, the Roth IRA would be the better choice.
You also have to look at the income limits and contribution limits. Here is a link to those limits for 2015. https://401k.fidelity.com/public/content/401k/Home/VPContributionLimits
One other factor is the ability to convert tradition IRA’s to Roth IRA’s. There are two scenarios that this may be of benefit to you. One is if you make more than the limits for Roth IRA’s, you can backdoor convert your IRA to a Roth. You need to make sure you don’t have other tradition IRA’s or 401(k)’s that you rolled into an IRA otherwise it won’t work properly. More info on the backdoor conversion can be found here: http://www.bogleheads.org/wiki/Backdoor_Roth_IRA
The other option for some people who retire early is to get their income way down during the early retirement years and use that time to convert IRA’s to Roth IRA’s during a time when they don’t pay much in taxes. If you really enterprising, you may actually be able to do that without paying any taxes, thereby getting the largest game. That type of tax planning requires you get an extensive education or find somebody who can help you plan the conversion. The most important thing is that you’re maximizing your contributions now and letting the power of compounding help you achieve your goals. You can learn more about the power of compounding here.
Lastly, the traditional IRA has required distributions that you must begin at 70 ½ while the Roth IRA does not force you to withdraw the money at any point under current rules.
The key to a nice retirement is to make sure you are putting away the funds now so you can take your seat above or wherever you choose.