Taxes remain a big reason. With a traditional account, your contributions are tax-deferred. After retirement, your withdrawals are taxed as regular income. It’s just the opposite for a Roth account.
At first glance, it doesn’t seem to make a difference which one you choose, if you assume your income tax rate remains unchanged after retirement.
Let’s assume you contribute $1,250 a year for 10 years to either a traditional or Roth IRA. If the balances grow 10% a year and the tax rate remains 20%, both the traditional and Roth IRAs would end up with $17,531 after taxes. It’s a wash. The traditional account had bigger gains, but the Roth IRA had lower taxes.
If taxes increase, however, the Roth IRA is clearly preferred. If you assume a higher 25% tax rate in retirement, the traditional account gets hit with almost $1,100 more in taxes that reduces the balance to $16,436. The amount in the Roth IRA remains unchanged.
Conversely, if your ordinary income tax rate is lower in retirement, the traditional IRA is better. Few see the government lowering tax rates in the future, but keep in mind that your income – and tax rate – would likely decline in retirement.
Tax liability alone isn’t a strong enough argument in favor of a Roth. You don’t want to end up gambling on what will happen with tax rates in the future. There are other factors in favor of Roth IRAs that I point out in my book, An IRA Owner’s Manual. Consider the following:
1. There is no required minimum distribution rule for the Roth IRA. With a traditional IRA, you have to start withdrawing funds at age 70½. Given your tax situation, you may want to delay tapping into your IRA.
2. Funds contributed to your Roth IRA may be withdrawn at any time, for any reason, with no tax penalty. Note that this only applies to annual contributions and not the earnings on the funds. This gives you access to your contributions as a sort of an emergency fund. Remember, however, early withdrawals could work against your long-term goals.
3. Since there’s never a tax on withdrawals, the amount of money you have in your Roth IRA is passed on in full to your beneficiaries. In certain cases, estate taxes could still apply.
In the end, both the traditional and Roth IRAs offer very distinct tax benefits. But make sure to consider the wider picture as well before selecting either.
Follow AdviceIQ on Twitter at @adviceiq.
Jim Blankenship, CFP, EA, is an independent, fee-only financial planner at Blankenship Financial Planning in New Berlin, Ill. He is the author of An IRA Owner’s Manual and A Social Security Owner’s Manual. His blog is Getting Your Financial Ducks In A Row, where he writes regularly about taxes, retirement savings and Social Security.
AdviceIQ delivers quality personal finance articles by both financial advisors and AdviceIQ editors. It ranks advisors in your area by specialty, including small businesses, doctors and clients of modest means, for example. Those with the biggest number of clients in a given specialty rank the highest. AdviceIQ also vets ranked advisors so only those with pristine regulatory histories can participate. AdviceIQ was launched Jan. 9, 2012, by veteran Wall Street executives, editors and technologists. Right now, investors may see many advisor rankings, although in some areas only a few are ranked. Check back often as thousands of advisors are undergoing AdviceIQ screening. New advisors appear in rankings daily.