Across financial blogs and social media, there is an ongoing debate about whether it’s best to invest in Roth IRAs/401(k)s or Traditional IRAs/401(k)s. There are merits for each, and under certain circumstances it may make sense for you to choose one over the other. But in general Roth is the way to go for the following reasons:
- It lets you save more money;
- It has advantages later in life and for your heirs;
- It may save you taxes; and
- It can be more flexible
Before providing more details on these points, let me start with some basics, and for the sake of making this read a bit easier, I’m going to refer to IRAs, 401(k)s, 403(b)s all simply as IRAs. The main difference between a Roth and Traditional IRA is when you pay the taxes on your investment. They both have tax deferred (or in the case of Roth, tax-free) growth, which allows your money to compound way faster than in a taxable account. In a Roth you pay taxes on your investment now and in a Traditional you defer it until you make withdrawals in retirement. Assuming two things: (1) your tax rate is about the same now as it will be when you make the withdrawals in retirement, and (2) you weren’t planning on maxing out the Roth amount anyway, then it doesn’t really matter which route you take. Except, as I argue below it does matter, and Roth is the way to go.
As a quick example of the math involved, let’s assume that you are 35 years old, in a 25% marginal tax bracket, and are deciding between investing $4,000 in a Traditional IRA (where you’ll get $1,000 in tax savings from the deduction this tax year) or an equal post-tax amount of $3,000 in a Roth IRA. Now, let’s assume that you don’t invest any more money in these accounts (unrealistic, I know), and that over a 30-year period, the accounts earn about a 7% average annual return, meaning that they go through three doublings in value over these 30 years. Then, at age 65, you plan on cashing these accounts out in full (again, this is just an example). At that time, the Traditional IRA’s balance with its tax-deferred growth will be $32,000 and the Roth IRA’s balance with its tax-free growth will be $24,000. When you take the withdrawal, the Roth IRA distribution is tax-free – you already paid taxes up front, so you net the full $24,000. With the Traditional IRA, however, you now owe taxes at your current marginal tax rate on the entire distribution. In this example, we’ll assume that your marginal tax rate is still the same 25% it was 30 years before, so the taxes owed will be $8,000, and your post-tax net will be $24,000, the exact same as with the Roth IRA.
Now that we see that both Traditional and Roth IRAs can leave you in the exact same place in retirement, let’s get into the details of the benefits of the Roth IRA over the Traditional IRA:
The Roth IRA Lets You Tax Shelter More Money
The current limit for an IRA contribution (disregarding catch-up contributions) is $5,500 per year regardless of whether you make a Traditional or Roth contribution or some combination of the two. If you go the Traditional route, that is exactly how much you can contribute: $5,500. But if you go the Roth route, then by saving $5,500 in a Roth, you effectively invested the equivalent of $5,500 divided by (1-your marginal tax rate).
Using my previous example of a 25% marginal tax rate, saving $5,500 in Roth is the same as saving $7,333.33 in a Traditional, which is well beyond the annual limit of what you’re allowed to save each year in a Traditional.
And the more your income, the more this equates to. For example, if you’re in the 37% marginal tax bracket, then saving $5,500 in a Roth is the same as saving $8,730.16 in a Traditional.
Using a Roth IRA simply lets you save more money in a vehicle that lets your money grow tax free, which means your money will grow that much faster. The same is true for 401(k)s and 403(b)s except that limit is much higher: $18,500.
Roth IRAs Have Advantages Later in Life and for Your Heirs
Unlike Roth IRAs, Traditional IRAs force you to take required minimum distributions (“RMDs”) once you reach 70 ½ years old. The IRS determines the amount based on a formula using your life expectancy. Keep in mind that in retirement most of your income will be generated by your assets and some years they’ll perform really well, and some years they will not. It would be nice if you could take money out of your IRA in years you need to supplement your income, but let it keep growing tax-deferred in years you don’t need the income. With a Traditional IRA, you don’t have this choice; you have to take the RMD or more every year. With a Roth IRA, there is never a requirement to withdraw any of the money on any timetable but your own.
This brings me to the next advantage later in life for Roth IRAs, and that is relating to estate planning. A Traditional IRA not only forces RMDs, but upon your death, if there is anything left in the IRA, your estate must pay taxes on all of it before passing on the post-tax balance to your heirs. A Roth IRA, however, not only allows you to maintain and grow its value with no RMDs, but upon your death, you may pass it on to your heirs as a Roth IRA. This means that your kids or grand kids can inherit this account without your estate paying taxes on it, and they can keep growing that investment tax free themselves. One caveat to this feature is that a Roth IRA can only be passed to an heir as a Roth IRA one time – the person who receives it may not pass it on again as a Roth IRA, but simply as cash value in his or her estate.
Roth IRAs May Actually Save You From Paying More In Taxes
I know this sounds counter-intuitive. If you put money in a Traditional IRA, it lets you deduct that contribution from your income this tax year so long as you are not above the deductibility phase out limits, which for most people are $73,000 of adjusted gross income if filing an individual return and $121,000 of adjusted gross income if filing a joint return. So you may expect that this means that you would save taxes by going the Traditional route.
For two reasons, however, the Roth very likely will save you in taxes:
- First, your tax rate may very well be higher in retirement even at a similar or slightly reduced income. We currently have historically very low marginal tax rates. Over most decades in America, marginal tax rates were higher at all levels of income, and it is likely that even if your income remains the same, it will be taxed more later in life. Going back to our example at the beginning where the Roth balance is $24,000 and the Traditional balance before withdrawal is $32,000, if your marginal tax rate at that time is anything over 25%, you would end up paying more taxes and netting less post-tax money. For example, if your marginal tax rate increased to 30%, then your taxes would be $9,600, and you’d only net $22,400, which is nearly 7% less than you net from the Roth investment.
- Second, if you’re reading this, you’re likely a prodigious saver and may have high enough assets and passive income later in life that your marginal tax rate will actually go up even if the brackets and percentages remain steady. And as I discussed above, this situation is further exacerbated by having Traditional IRA assets in retirement because you’ll be forced to take RMDs each year, even in years where you already have plenty of other income.
Roth IRAs Are More Flexible Than Traditional IRAs
Beyond all the reasons detailed above why Roth IRAs are superior to Traditional IRAs, there are still a few more reasons:
- You can generally withdraw your Roth IRA contributions penalty-free before age 59 ½ at any time for any reason, unlike a Traditional which requires special exceptions like a first home purchase, permanent disability, paying back taxes, or certain health expenses. Absent one of these exceptions, there is a 10% penalty plus you must pay tax on any early withdrawals from a Traditional IRA. Please keep in mind that the ability to withdraw your Roth IRA contributions penalty and tax free before reaching age 59 ½ does not apply to your earnings nor to conversions made in the past five years.
- You can contribute to a Roth IRA after you turn 70 ½. Not only is this the age where Traditional IRAs force you take RMDs, but this is also the age where you are precluded from even investing in a Traditional IRA.
- I saved my favorite feature for last: the backdoor Roth IRA. In 2018, you may only contribute to a Roth IRA (directly) if your adjusted gross income is below $135,000 as an individual filer or $199,000 as a married couple (and phaseouts start slightly lower than that). Furthermore, although there is no income cap on contributing to a Traditional IRA, you may only deduct your contribution on your taxes that year if your adjusted gross income is below $73,000 as an individual filer or $119,000 as a married couple (also with phaseouts starting slightly before these figures). If your income is above the Traditional IRA deductibility limits than you should certainly contribute to a Roth IRA instead, and if your income is also above the direct Roth IRA contribution limit, then doing a backdoor Roth IRA is a no-brainer. In this case, your Traditional contribution would be post-tax anyway (meaning non-deductible) and if you left the investment as a Traditional IRA, it would still grow tax-deferred, but not tax free. Whereas, by making an election on your broker’s website and including a simple filing with your taxes to convert your post-tax Traditional IRA to a Roth IRA, it will now grow tax-free and have all of the other benefits discussed above as a Roth IRA.