One of the questions clients ask most often is whether they should invest in a Roth IRA or Traditional IRA. There is no one right answer – as with most issues in financial planning, it depends upon your specific situation.
The advantage of a traditional IRA is that the contribution is tax deductible. So if you, like millions of Americans, are looking for a way to reduce what you owe at tax time, the traditional IRA can be attractive. Beyond the tax deduction, the account isn’t taxed as it grows, but any withdrawals you do make are taxed in the year you make them. In addition, even if you’d like to avoid taking withdrawals to avoid the tax, the government makes you begin taking withdrawals once you’ve reached the age of 70.5.
Unlike the traditional IRA, a contribution to a Roth IRA is not tax deductible. Once you’ve made the contribution, as long as you follow certain rules with regards to when you withdraw from a Roth, the funds in the Roth are never taxed again. The growth in the account isn’t taxed, and the withdrawals aren’t taxed either (subject to the rules mentioned above). In a sense, you can think of a traditional IRA as a way to set aside retirement savings, while a Roth is a vehicle to save for retirement and prepay taxes.
Making the Roth vs. traditional IRA decision through the lens of whether you should prepay taxes is helpful, as it leads to a few clarifying questions including:
- How does your current tax rate compare to your likely future tax rate? Predicting future tax rates is a guessing game, but if you think it’s likely your future tax rate will be below your current tax rate, the traditional IRA might make more sense for you.
- How long will your investment have to grow in the Roth to offset for prepaid taxes? The answer to this question has a few moving parts, so an example will help. Let’s assume you have $5000 in cash on hand. If you make the traditional IRA contribution, it will reduce the amount you owe in taxes to zero, so you can afford to contribute the entire amount to the IRA. If you make a Roth contribution, on the other hand, the lack of a deduction means you’ll owe $1,000 in taxes. Since you only have $5,000 in cash, you’ll need to use $1,000 to pay taxes leaving you with only $4,000 to contribute to the Roth.
Assuming they are invested in the same diversified portfolio, the amount in the traditional IRA will always be greater than the amount in the Roth. But, the longer the two portfolios have to grow before you need to make a withdrawal, the larger both accounts will be and the greater the tax will be on the traditional IRA when you have to begin taking withdrawals. The end result is that even though less money is invested in the Roth up front, the longer the timeframe of the investment, the greater the likelihood that you’ll be able to draw more net income from the Roth in retirement than you can from a traditional IRA from which withdrawals are taxable.
Not everyone is eligible to make Roth IRA or traditional IRA contributions, so make sure you understand the eligibility requirements. If you aren’t eligible, you may find that you have a Roth option available in your 401k or 403b, and if you do, you can follow the same process to choose between Roth and IRA contributions. As outlined above, one key issue in making the decision whether pre-paying your taxes is likely to make sense for you.
Micah Porter is a fee-only financial advisor located in Atlanta (Decatur). For more information please contact us.