Regular IRA vs. Roth IRA | Choosing Between a Traditional versus Roth IRA

by RJ

in Investing

LeBron James did a poor job with his decision. Here are some guidelines on making the right decision between a Regular vs. Roth IRA.

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.

  1. Traditional IRA, which is commonly mispronounced as “Regular IRA”
  2. 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 The advantage is that contributions and earnings in a Roth IRA, grow and are withdrawn tax free.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  • All funds withdrawn before the age of 59 ½, with a few exceptions, are subject to a 10% penalty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  • Contributions and earnings are not taxed if withdrawn after 59 ½ and 5 years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:

  1. Invest in a Traditional 401(k) up to the employer match
  2. Max out a Roth IRA
  3. 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?

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Photo by: Craig Hatfield

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{ 5 comments… read them below or add one }

Pat S.No Gravatar April 15, 2011 at 2:22 pm

Great article. It’s great to review the basics from time to time.

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RJ WeissNo Gravatar April 15, 2011 at 4:13 pm

Of Course. It’s probably a top three question for readers.

Important and basic, but overlooked, in my opinion.

Reply

ClaudiaNo Gravatar April 26, 2011 at 11:33 am

As a widower at 58 I rolled over my 401K into a Traditonal IRA. No one advised me to do otherwise and I wish I had gone ahead and rolled it into a Roth instead. I am considering this option now but in baby steps as the taxes could be overwhelming. Thanks for the informative article.

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LeslieNo Gravatar April 27, 2011 at 1:36 pm

How would you rank asset location if there is a Roth 401K in the mix? Right now, that is my top investment vehicle.

Thanks.

Reply

Bret @ Hope to ProsperNo Gravatar April 29, 2011 at 12:07 am

I have an IRA, a Roth IRA and a 401K. I converted my original IRA to a Roth IRA many years ago, when the first conversion opportunity was available. This let me convert to a Roth and pay the taxes over 3 years. The reason I chose to do this was because I felt like income taxes will be higher in the future than they are now. I also hope to have substantial income from investments, which will probably put me in a higher tax bracket.

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