As a Financial Planner, I often get asked if people should save money in a Traditional IRA or a Roth IRA. In a Traditional IRA, we contribute money on a pre-tax basis (i.e. we do not pay taxes on our IRA contributions), we let it grow tax-deferred, and we pay taxes when we withdraw the money in retirement. In a Roth IRA, we contribute after-tax money, we let it grow tax-free and we pay no taxes when we withdraw the money in retirement.
That last point (“we pay no taxes when we withdraw the money in retirement”) is, of course, the one that gets our attention. We don’t like paying taxes, and the thought that we could have tax-free income in retirement is really motivating, so much so, that, sometimes, it can be the only thing we focus on.
However, the Traditional IRA vs Roth IRA story is not quite that straightforward.
The reality is that we WILL pay taxes whether it is for a Roth IRA or a Traditional IRA. With the Traditional IRA tax deduction, we reduce taxes at contribution, and we pay taxes when we withdraw the money. With a Roth IRA, we pay taxes before we contribute the money. At the risk of disappointing many readers, allow me to repeat: the Roth IRA is NOT tax-free, it is taxed differently.
When you do the math you will find that if you 1) invest in the same way in a Roth IRA vs IRA, and 2) are taxed at the same rate on your Roth IRA contribution today, as on your Traditional IRA withdrawals at retirement, you will end up with the exact same amount of money to spend in retirement. Call us: we will show you the math.
So which one is best? The answer is that it depends.
In general, it makes sense to invest through a Roth IRA when we think that our tax rate in retirement will be equal to or higher than our current tax rate. If we think that our tax rate in retirement will be equal or lower than our current tax rate it makes better sense to invest through a Regular IRA.
How then should you decide?
It depends on your situation.
For instance, if you are at the peak of your earnings, and you can calculate that your income in retirement will be significantly less than it is today, a Traditional IRA calculator will tell you that you will save tax money immediately. Since you expect to be in a lower tax bracket at retirement, you will end up paying less taxes.
If you are currently a low earner, and expect to have higher income in retirement than you have now, a Roth IRA calculator will thell you that your cost in taxes will be relatively low, and you will not pay any more when you retire.
Because there are many phases in our working life, there are times when it makes better sense to invest through a Roth IRA or Roth 401(k), and other times when it makes better sense to invest through a Traditional IRA or a Traditional 401(k). Conversely, there will be times in our retired life when it will make better sense to withdraw from a Roth IRA, and others when it will make better sense to withdraw from a Traditional IRA.
There are some other constraints. For instance, the traditional IRA max contribution is significantly lower than the 401(k). In addition, if your income is above the Traditional IRA income limits or the Roth IRA limit you may not be able to contribute.
It is about balance and careful financial planning. In the right circumstances, the proper balance between Roth and Traditional IRAs could save you a significant tax bill. In my opinion, it justifies a consultation with a professional financial planner.