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The Roth IRA versus traditional IRA debate has raged on for years.
What many retirement savers may not know is that most of the debate about whether it’s better to contribute to a traditional IRA or a Roth IRA is flawed.
You’ve probably heard that young investors are better off contributing to a Roth IRA because they’ll likely be in a higher tax bracket when they’re older. You’ve probably also heard that if you’re in the same tax bracket now and in retirement, a traditional IRA and Roth IRA will produce the same result.
These arguments are part of the conventional wisdom upon which many people make their decisions, and yet each misses some important nuance and, in some cases, is downright incorrect.
Here’s what we’ll cover:
How much would you like to invest?
There are several differences between traditional and Roth IRAs, and we’ll get into many of them below.
The key difference is in the tax breaks they offer.
Contributions to a traditional IRA are not taxed up front. They are tax-deductible, meaning they decrease your taxable income for the year in which you make the contribution. The money grows tax-free inside the account. However, your withdrawals in retirement are treated as taxable income.
Contributions to a Roth IRA are taxed up front at your current income tax rate. The money grows tax-free while inside the account. And when you make withdrawals in retirement, those withdrawals are not taxed.
Whether it’s better to get the tax break when you make the contribution or when you withdraw it in retirement is the centerpiece of the traditional vs. Roth IRA debate, and it’s also where a lot of people use some faulty logic.
We’ll debunk the conventional wisdom in just a bit, but first we need to take a very quick detour to understand a couple of key tax concepts.
Don’t worry. We’re not going too far into the tax weeds here. But there’s a key point that’s important to understand if you’re going to make a true comparison between traditional and Roth IRAs, and that’s the difference between your marginal tax rate and your effective tax rate.
When people talk about tax rates, they’re typically referring to your marginal tax rate. This is the tax rate you pay on your last dollar of income, and it’s the same as your current tax bracket. For example, if you’re in the 15% tax bracket, you have a 15% marginal tax rate, and you’ll owe 15 cents in taxes on the next dollar you earn.
Your effective tax rate, however, divides your total tax bill by your total income to calculate your average tax rate across every dollar you earned.
And these tax rates are different because of our progressive federal income tax, which taxes different dollars at different rates. For example, someone in the 15% tax bracket actually pays 0% on some of their income, 10% on some of their income, and 15% on the rest of their income. Which means that their total tax bill is actually less than 15% of their total income.
For a simple example, a 32-year-old couple making $65,000 per year with one child will likely fall in the 15% tax bracket. That’s their marginal tax rate.
But after factoring in our progressive tax code and various tax breaks like the standard deduction and personal exemptions, they will only actually pay a total of $4,114 in taxes, making their effective tax rate just 6.33% (calculated using TurboTax’s TaxCaster).
As you can see, the couple’s effective tax rate is much lower than their marginal tax rate. And that’s almost always the case, no matter what your situation.
Keep that in mind as we move forward.
Most of the discussion around traditional and Roth IRAs focuses on your marginal tax rate. The logic says that if your marginal tax rate is higher now than it will be in retirement, the traditional IRA is the way to go. If it will be higher in retirement, the Roth IRA is the way to go. If your marginal tax rate will be the same in retirement as it is now, you’ll get the same result whether you contribute to a traditional IRA or a Roth IRA.
By this conventional wisdom, the Roth IRA typically comes out ahead for younger investors who plan on increasing their income over time and therefore moving into a higher tax bracket or at least staying in the same tax bracket.
But that conventional wisdom is flawed.
When you’re torn between contributing to a traditional or Roth IRA, it’s almost always better to compare your marginal tax rate today to your effective rate in retirement, for two reasons:
And when you look at it this way, comparing your marginal tax rate today to your effective tax rate in the future, the traditional IRA starts to look a lot more attractive.
Let’s run the numbers with a case study.
Mark and Jane are 32, married, and have a 2-year-old child. They currently make $65,000 per year combined, putting them squarely in the 15% tax bracket.
They’re ready to save for retirement, and they’re trying to decide between a traditional IRA and a Roth IRA. They’ve figured out that they can afford to make either of the following annual contributions:
So the big question is this: Which account, the traditional IRA or Roth IRA, will give them more income in retirement?
Using conventional wisdom, they would probably contribute to the Roth IRA. After all, they’re young and in a relatively low tax bracket.
But Mark and Jane are curious people, so they decided to run the numbers themselves. Here are the assumptions they made in order to do that:
You can see all the details laid out in a spreadsheet here, but here’s the bottom line:
In other words, the traditional IRA will provide an extra $2,075 in annual income for Mark and Jane in retirement.
That’s a nice vacation, a whole bunch of date nights, gifts for the grandkids, or simply extra money that might be needed to cover necessary expenses.
It’s worth noting that using the assumptions above, Mark and Jane are in the 15% tax bracket both now and in retirement. According to the conventional wisdom, a traditional IRA and Roth IRA should provide the same result.
But they don’t, and the reason has everything to do with the difference between marginal tax rates and effective tax rates.
Right now, their contributions to the traditional IRA get them a 15% tax break, meaning they can contribute 15% more to a traditional IRA than they can to a Roth IRA without affecting their budget in any way.
But in retirement, the effective tax rate on their traditional IRA withdrawals is only 10%. Due again to a combination of our progressive tax code and tax breaks like the standard deduction and personal exemptions, some of it isn’t taxed, some of it is taxed at 10%, and only a portion of it is taxed at 15%.
That 5% difference between now and later is why they end up with more money from a traditional IRA than a Roth IRA.
And it’s that same unconventional wisdom that can give you more retirement income as well if you plan smartly.
The main takeaway from everything above is that the conventional traditional versus Roth IRA wisdom is wrong. Comparing marginal tax rates typically underestimates the value of a traditional IRA.
Of course, the Roth IRA is still a great account, and there are plenty of situations in which it makes sense to use it. I have a Roth IRA myself, and I’m very happy with it.
So here are five good reasons to use a Roth IRA.
Our case study above assumes that you would make equivalent after-tax contributions to each account. That is, if you’re in the 15% tax bracket, you would contribute 15% less to a Roth IRA than to a traditional IRA because of the tax cost.
That’s technically the right way to make the comparison, but it’s not the way most people think.
There’s a good chance that you have a certain amount of money you want to contribute and that you would make that same contribution to either a traditional IRA or a Roth IRA. Maybe you want to max out your contribution and the only question is which account to use.
If that’s the case, a Roth IRA will come out ahead every time simply because that money will never be taxed again.
If you make too much to either contribute to a Roth IRA or deduct contributions to a traditional IRA, you still might be eligible to do what’s called a backdoor Roth IRA.
If so, it’s a great way to give yourself some extra tax-free income in retirement, and you can only do it with a Roth IRA.
Social Security income was already factored into the example above. But any additional income, such as pension income, would increase the cost of those traditional IRA withdrawals in retirement by increasing both the marginal and effective tax rate.
Depending on your other income sources, the tax-free nature of a Roth IRA may be helpful.
You can make the most reasonable assumptions in the world, but the reality is that there’s no way to know what your situation will look like 30-plus years down the road.
We encourage people to diversify their investments because it reduces the risk that any one bad company could bring down your entire portfolio. Similarly, diversifying your retirement accounts can reduce the risk that a change in circumstances would result in you drastically overpaying in taxes.
Having some money in a Roth IRA and some money in a traditional IRA or 401(k) could give you room to adapt to changing tax circumstances in retirement by giving you some taxable money and some tax-free money.
Roth IRAs are extremely flexible accounts that can be used for a variety of financial goals throughout your lifetime.
One reason for this is that your contributions are available at any time and for any reason, without tax or penalty. Ideally you would be able to keep the money in your account to grow for retirement, but it could be used to buy a house, start a business, or simply in case of emergency.
Roth IRAs also have some special characteristics that can make them effective college savings accounts, and as of now Roth IRAs are not subject to required minimum distributions in retirement, though that could certainly change.
All in all, Roth IRAs are more flexible than traditional IRAs in terms of using the money for nonretirement purposes.
People love the Roth IRA because it gives you tax-free money in retirement, but, as we saw in the case study above, that doesn’t always result in more retirement income. Even factoring in taxes, and even in situations where you might not expect it, the traditional IRA often comes out ahead.
And the truth is that there are even MORE tax advantages to the traditional IRA than what we discussed earlier. Here are three of the biggest.
One of the downsides of contributing to a Roth IRA is that you lock in the tax cost at the point of contribution. There’s no getting that money back.
On the other hand, contributing to a traditional IRA gives you the tax break now while also preserving your ability to convert some or all of that money to a Roth IRA at your convenience, giving you more control over when and how you take the tax hit.
For example, let’s say that you contribute to a traditional IRA this year, and then a few years down the line either you or your spouse decides to stay home with the kids, or start a business, or change careers. Any of those decisions could lead to a significant reduction in income, which might be a perfect opportunity to convert some or all of your traditional IRA money to a Roth IRA.
The amount you convert will count as taxable income, but because you’re temporarily in a lower tax bracket you’ll receive a smaller tax bill.
You can get pretty fancy with this if you want. Brandon from the Mad Fientist, has explained how to build a Roth IRA Conversion Ladder to fund early retirement. Financial planner Michael Kitces has demonstrated how to use partial conversions and recharacterizations to optimize your tax cost.
Of course, there are downsides to this strategy as well. Primarily there’s the fact that taxes are complicated, and you could unknowingly cost yourself a lot of money if you’re not careful. And unlike direct contributions to a Roth IRA, you have to wait five years before you’re able to withdraw the money you’ve converted without penalty. It’s typically best to speak to a tax professional or financial planner before converting to a Roth IRA.
But the overall point is that contributing to a traditional IRA now gives you greater ability to control your tax spending both now and in the future. You may be able to save yourself a lot of money by converting to a Roth IRA sometime in the future rather than contributing to it directly today.
Traditional IRA contributions are deductible for state income tax purposes as well as federal income tax purposes. That wasn’t factored into the case study above, but there are situations in which this can significantly increase the benefit of a traditional IRA.
First, if you live in a state with a progressive income tax code, you may get a boost from the difference in marginal and effective tax rates just like with federal income taxes. While your contributions today may be deductible at the margin, your future withdrawals may at least partially be taxed at lower rates.
Second, it’s possible that you could eventually move to a state with either lower state income tax rates or no income tax at all. If so, you could save money on the difference between your current and future tax rates, and possibly avoid state income taxes altogether. Of course, if you move to a state with higher income taxes, you may end up losing money on the difference.
Contributing to a traditional IRA lowers what’s called your adjusted gross income (AGI), which is why you end up paying less income tax.
But there are a number of other tax breaks that rely on your AGI to determine eligibility, and by contributing to a traditional IRA you lower your AGI you make it more likely to qualify for those tax breaks.
Here’s a sample of common tax breaks that rely on AGI:
There’s a lot more to the traditional vs. Roth IRA debate than the conventional wisdom would have you believe. And the truth is that the more you dive in, the more you realize just how powerful the traditional IRA is.
That’s not to say that you should never use a Roth IRA. It’s a fantastic account, and it certainly has its place. It’s just that the tax breaks a traditional IRA offers are often understated.
It’s also important to recognize that every situation is different and that it’s impossible to know ahead of time which account will come out ahead. There are too many variables and too many unknowns to say for sure.
But with the information above, you should be able to make a smarter choice that makes it a little bit easier to reach retirement sooner and with more money.
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Matt BeckerMatt Becker is a CERTIFIED FINANCIAL PLANNER™ and the founder of Mom and Dad Money. His work is published in The New York Times, NPR, The Washington Post and Money Magazine.
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