Welcome once again to the little corner of the blog where we discuss some of the greatest arguments in the personal finance world. Today, we’ll discuss which is better when planning for your retirement, a traditional IRA or a Roth IRA. (There are also traditional and Roth flavors of 401(k)s, as well, but since that choice will be made by your company and its human resources department, you’ll have less control over which variety you will have.)
The big difference between the two types of IRAs is when the the money you invest in them is taxed. In traditional IRAs, the money you invest is taken from your taxable income, allowing you pay fewer taxes now, but the withdrawals when you retire are taxed at your regular tax rate. Roth IRAs are funded with after-tax money and the withdrawals are tax-free. The decision then becomes when you want to be taxed, now or when you retire.
Therefore, there’s a simple way to determine which type of IRA will be better for you: hop into your time machine, travel forward to the time you retire, and see what tax rates you will be paying. If the rates are higher in the future than they are now, you’ll do best financially with a Roth; if the rates are lower (or if the Fair Tax has been enacted), than a traditional IRA is the way to go. Then, come back to the present and open that style of IRA; easy as pie!
What’s that? You don’t have a time machine? That complicates matters a bit. You can still choose the style of IRA you open based on what you think the future will hold for tax rates. Personally, given the rising national debt and rather low current tax rates, I would imagine that tax rates are only going to rise in the future (although, again, the Fair Tax or other non-income taxes could drastically change the tax landscape), making Roth accounts more attractive. Some other questions to ask yourself:
Will I need more or less money in retirement? – As a consequence of our graduated tax system, the less income you have, the lower taxes you pay as a percentage of your income. Thus, since different IRAs allow you to be taxed at different times, you can attempt to determine how much money you will need to spend in retirement. If you intend to cut down your spending when you retire, even just to the 70-80% of your final income that many experts say that you need, traditional IRAs should be beneficial; if you intend to maintain or increase your current level of spending, a Roth IRA will help you dodge the tax burden.
Do you want to lock in your tax rate? – One of the biggest advantages of a Roth is that you know what tax rate you are paying now (or at least, should be able to figure it out), and therefore know exactly what you are paying in taxes. As we’ve already discussed, though, tax rates in the future are a big unknown. If you prefer to pay your current tax rate and not have to worry about tax increases in the future, a Roth provides you with that opportunity. On the other hand, if you are currently in a high tax bracket, taking a tax break now for your traditional IRA may make the most sense.
(If your taxable income is high enough, you may not even have the option of using a Roth. For single filers, you can put in the maximum ($5000) if you earn less than $105,000 in 2009, with partial contributions allowed up to an income of $120,000; married couples filing jointly can donate up the max if they earn less than $166,000, and partial donations up to $176,000. A complete matrix comparing income limits and other factors affecting traditional versus Roth IRAs and 401(k)s can be found here.)
Am I diversified? – Diversification isn’t just about holding a variety of investments, it also involves ensuring that your portfolio is prepared for whatever the tax rates do in the future. If you have a traditional 401(k) at your work place, having a Roth IRA to help in case of rising taxes is a good way to diversify. Similarly, if you are one of the lucky ones who has a Roth 401(k), having a traditional IRA can help to lower you current tax burden and help to minimize the taxes you will pay overall.
These questions, as well as your thoughts about how taxes will change in the future, will help you to decide which type of IRA will be best for you. As is frequently the case, there is no easy answer to which type of account is better that applies to everyone equally, but hopefully, asking yourself questions about your tax rate, future spending, and the types of other accounts you hold will help you to make some good decisions. Happy retirement planning!