Wednesday, April 10, 2013

The Battle of the IRAs: Roth versus Traditional

I am surprised that the question I am asked most often is, “Should I get a Roth IRA or a Traditional IRA?”[i]   Most people know that a conventional IRA allows you to put money in savings without paying taxes on the money before you make the deposit.  When you withdraw the money, in retirement, ordinary income taxes are levied on the entire withdrawal.   On the other hand, with a Roth IRA, deposits are made after you pay taxes.  Then, upon retirement withdrawal, no taxes are due.  Like most financial matters, consumers try to make this decision much harder than it actually is.  First, I’ll give my answer and, for most people, the Roth is preferred.  I will explain why, later.  Let us begin by comparing the options with math, so we understand the basics.  As with most math problems, we have to set forth some assumptions. 

·         We will assume a person in the 25% marginal tax bracket.

·         We assume the choice is between a deposit of $5,500 in before-tax dollars (the 2013 limit for IRA deposits) into a conventional IRA or $4,125 in after-tax dollars into a Roth IRA[ii].  The reason for the difference is that we are holding current earned income constant, as the $5,500 in earnings becomes $4,125 after paying 25% in taxes.

·         The account is invested for 40 years at 8%.

Under these assumptions, the conventional IRA will grow to $119,485 which, upon paying taxes at 25% on withdrawal, becomes $89,614.  The $4,125 Roth deposit will grow to $89,614, as all taxes have been paid before the original deposit.  Conclusion, if we hold the earnings required to make the initial deposit and the tax rate constant, there is no difference in what the retiree has to spend in retirement.  If, however, their tax rate is greater in retirement than while working, the Roth IRA would best her traditional cousin, and if the household’s tax rate is lower in retirement, the traditional IRA would best his Roth cousin.   


The reasons why the Roth is preferred for most people follow.


1.       If your company offers a Roth 401k, you may make larger contributions.  For 2013, the maximum is $17,000, unless you are a geezer like me and over 50.  If you are of such vintage, the maximum is $23,000.

2.       If you need money from your Roth IRA, you can withdraw you contributions (not interest, dividends, or capital gains) for any use without penalty, as you’ve already paid the taxes.  Thus your Roth can double as a savings account.  (It is for your retirement so leave it alone!)

3.       When you die, the money that remains in your Roth IRA is not taxable income.  Money that is in a traditional IRA has income taxes that must be paid by your heirs.

4.       Since taxes have been paid on the corpus of the Roth IRA, your investment decisions will not be affected by tax considerations.   Conventional IRAs are often held out as a better place to invest in securities that pay interest and dividends, as these will not be taxed until withdrawal.  This is, however, also true with capital gains.  The bad news is that those capital gains will be taxed at greater ordinary income rates, as opposed to capital gain tax rates, if held outside of the conventional IRA.

5.       With a traditional IRA you must begin to take withdrawals (i.e., pay taxes) on the money at the age of 70½.  (The government wants to get the money you “owe” them.)  Since you’ve paid taxes on the Roth, there are no requirements for withdrawals and, thus, increases the use of the Roth IRA as tool for bequests.  You can also continue to make contributions to a Roth IRA, after the age of 70½.  You cannot contribute to a traditional IRA after the age of 70½.

6.       Roth IRA income is not subject to taxes and, thus, may prevent your retirement income from being large enough to cause your Social Security to become taxable.  Moreover, with a lower taxable income, you are less likely to be charged greater premiums for Medicare.

7.       Lastly, both Roth and conventional IRAs allow you to withdraw $10,000, once in your lifetime, if you are a first-time homebuyer, or a buyer who has not owned a home for two years.   This can be a wonderful opportunity for a young person to use their retirement plan, of either flavor, to purchase a home.  The only provision is that the money has to have been in the plan for at least five years.

I hope this helps answer your questions or, if you are young, gets you started on saving some of your earned income in a retirement plan.  While the laws governing these options may change one thing will never change, financial success begins with your disciplined saving plan.


[i] We will use the term IRA with the understanding that the information is able to be generalized to 401k, 403b, and other retirement plans that have both conventional and Roth options.

[ii] If you are eligible in 2013, you can contribute up to the $5,500 maximum into the Roth IRA but, in order to do so, you’d have to use earnings of $7,333, in order to have $5,500 after you pay taxes of 25%.  We are holding earnings constant at $5,500, in order to have a fair comparison.


David said...

These are very useful investment tips. I will recommend to my friends for reading this blog.

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Melody Rosenbaum said...

This is a very informative post! It’s a great idea that you presented the topic using a mathematical computation and assumed it in a real situation so that your readers can easily understand what you want to express. Retirement plans are helpful investments and I think if you still need more information about this, you can consult professional help.