Choosing between a Traditional versus Roth IRA, is one of the first BIG investment decisions you’ll make. With 40+ years of compounded returns ahead, your decision has large implications. The right choice can save you thousands of dollars in taxes now and in the future. While the wrong choice, can cost you thousands of dollars in taxes.
The purpose of this post is to compare the two types of IRAs for individual investors. In addition, offer guidelines for making the optimal choice.
What is a IRA?
First, some background on the IRA, itself.
IRA stands for Individual Retirement Account.
IRAs, aren’t investments. It’s a holding account for investments.
Investment held inside IRAs, are taxed differently than investments held outside.
There are two main types of IRAs for individual investors.
- Traditional IRA, which is commonly mispronounced as “Regular IRA”
- Roth IRA
Traditional versus Roth IRA
The difference between a Traditional versus Roth IRA, is the way they’re taxed. Both types of IRAs offer tax advantages, but they do so in different ways.
If you contribute to a Traditional IRA, you receive a tax deduction in the year you make the contribution. Thus, lowering your taxable income for the year. Your contributions and earnings are then tax-deferred until you withdrawal them in retirement.
A Roth IRA is the opposite, you receive no tax deduction for contributing to a Roth IRA. The advantage is that contributions and earnings in a Roth IRA, grow and are withdrawn tax free.
Other differences, include…
Advantages of Traditional IRAs
- Contributions are tax-deductible in the year they’re made, which lowers your taxable income for the year
- Contributions and earnings are tax-deferred until withdrawal
Disadvantages of Traditional IRAs
- Pay ordinary income tax on contributions and earnings at the time of withdrawal
- All funds withdrawn before the age of 59 ½, with a few exceptions, are subject to a 10% penalty
- Must start withdrawing at 70 1/2
Advantages of Roth IRAs
- Contributions and earnings are not taxed if withdrawn after 59 ½ and 5 years
- The maximum amount you can contribute has more value because contributions are made with after-tax dollars.
- If marginal tax rates are lower now, one can prepay them, instead of paying them at a higher rate later.
- No mandatory distribution age
- Can withdrawal contributions not earnings, subject to a few restrictions
Disadvantages of Roth IRAs
- No tax deduction for current year for contributing
- Pay state income tax now, even if you plan to retire in a state without an income tax.
- Lose chance to rollover in future, in a year in which your marginal tax rate is low.
- Lose chance to claim tax credits if your income is on the borderline
Some General Guidelines
In my opinion, the majority of investors in their 20’s and early 30’s, are better off investing in a Roth IRA. The reason I find the Roth to have an advantage, is that essentially the Roth IRA has a greater contribution limit because it’s made with after-tax dollars.
As a general rule for asset location, one should invest in this order:
- Invest in a Traditional 401(k) up to the employer match
- Max out a Roth IRA
- Max out a Traditional 401(k)
Examples of Outliers
If the majority of people should invest in a Roth IRA, what then are examples of the small minority? Here are a few that come to mind:
- Someone on the border line of receiving a tax credit, and needs to reduce the income to do so.
- Someone who currently works in a state with a high income tax, that plans to move to a state with a low-income tax during retirement.
- Someone who pays a high income tax, but doesn’t contribute the maximum allowed of $5,000.
- Someone who plans to take a year off or return to school, and then have the option of rolling over that year.
Regular IRA vs Roth IRA | Conclusion
In the comments, to give examples to more novice readers, I would love to hear why you contribute to either a Traditional or Roth IRA. When you made the decision, what was the determining factor?
Photo by: Craig Hatfield