How To Decide Between Roth IRA or Traditional IRA?

November 22nd, 2007  |  Published in Retirement  |  6 Comments

The allure of tax-free appreciation of funds sure is tempting isn’t it? That’s what a Roth IRA brings to the table since you contribute post-tax dollars that can grow (or shrink) absolutely tax free.

The allure of a tax deduction and “more” assets to appreciate sure is tempting isn’t it? That’s what a Traditional IRA brings to the table since you deduct your contributions (making them pre-tax) and thus start with more funds.

So which one is better?

That’s difficult to say and for many people the decision isn’t as clear cut as I’ve just made it. If your employer offers a 401(k) and you earn over a certain amount, Traditional IRA contributions are not tax deductible. If you earn too much, a Roth IRA may not even be an option for you. However, let’s say you fall into that middle area and need to make a decision… here’s how I would handle it.

Question 1: Do you have a 401(k) that you contribute to?

If the answer is yes, then I’d go with a Roth IRA from the perspective of tax profile diversification. In a nutshell, tax profile diversification means you shouldn’t have all your retirement funds in tax-free or tax-deferred accounts. You should try to have a mix of both because you don’t know what will happen in the future. 401(k)’s are tax deferred whereas Roth IRAs are tax free, so having both is valuable.

Question 2: Will you be in a higher tax bracket in retirement?

It used to be that the answer is clearly no but now it’s not so clear. Our tax rates are historically low (percentage wise) so it begs to wonder whether or not we should shift our tax burden to today in anticipation of higher rates in the future. If you think your tax rates will be higher in the future, you’d want to pay the tax now. If you think your tax rates will be lower in the future, you’d want to defer the tax until the lower rate. If you have no idea or think they will be the same, you might as well defer the tax because paying the man in 40 years is better than paying the man right this second.

Question 3: There is no question three!

You’re done! Two questions is all it takes to figure out which one is best for you, unfortunately question 2 is a doozy and requires a bit of seeing the future. That’s great if you can see the future, but for those of us who can’t… just guess and you’ll do alright.

  

Responses

  1. Pinyo says:

    November 23rd, 2007 at 2:41 pm (#)

    Excellent way to look at a tough question to answer. I am in camp #1, where I shoot for “tax profile diversification”. Did you make that up yourself? Clever. 😉

  2. Moolanomy weekly roundup #16: “Prosper” edition | Moolanomy says:

    November 25th, 2007 at 10:07 am (#)

    […] How To Decide Between Roth IRA or Traditional IRA? @ My Retirement Blog […]

  3. Honest Dollar says:

    December 9th, 2007 at 11:11 pm (#)

    What if your employer offers a Roth 401(k) as well as a regular 401(k)? Then you have 4 options for retirement (the 401(k)s plus a traditional IRA and a Roth IRA): 2 tax deferred, 2 tax free. Any advice on how to allocate between these 4 options for tax diversification?

  4. Abdulrasool says:

    March 30th, 2008 at 2:22 pm (#)

    America’s future tax rates in my view will be a lot higher than they are today. Why? First let’s consider this fact:

    The Outstanding Public Debt as of 30 Mar 2008 at 06:15:22 PM GMT is: $9,417,087,048,915. The estimated population of the United States is 303,718,028 so each citizen’s share of this debt is $31,006.02.
    Source: Search for “debt” in Google and look @ the US National Debt Clock.

    The War in IRAQ is far from over. Bush is spending billions of dollars there and wasting Americas’ taxpayer money. Future governments will likely continue this game of racking up billions and billions more of debt. How will they be able to pay for this ever increasing debt? There are 2 ways:

    i) Print more money which seems to be Ben Bernanke’s favourite thing to do during these volatile stock market times. This will just lead to more inflation and decreasing purchase power parity.

    ii) Raise taxes, increasing the burden on the average American consumer.

    Therefore, the Roth IRA in my opinion is a lot better than Traditional IRAs. Here’s an interesting statement from http://www.definerothira.com

    By making after-tax contributions to your Roth IRA, you will not owe a single dime of tax to Uncle Sam when you retire and withdraw your money. This adds the advantage of being able to grow your earnings tax-free not for the government, but for yourself! Which retirement plan is therefore the right choice for you? Well it depends on your personal situation. If you expect to be in a higher tax bracket when you retire, it is better off to pay the taxes right now and grow your savings tax-free in a Roth IRA. Because a Roth IRA holds after-tax dollars, you can maximize your contributions by adding greater tax leverage to your retirement savings.

    You guys agree/disagree? Let’s hear some constructive criticism!

  5. Roth IRA Explained » Roth IRA or Traditional IRA? says:

    April 24th, 2008 at 9:49 am (#)

    […] Here is another post on My Retirement Blog discussing how to choose between Roth IRAs and Traditional IRAs. […]

  6. C-Rex says:

    April 14th, 2009 at 6:03 pm (#)

    Very useful and to the point!
    Thanks!