Roth IRA vs. Traditional IRA: The Complete Guide for Wise Investors

September 25, 2017

After earning my first paycheck, I opened up an IRA.

When setting up my first IRA, I began reading about retirement planning and realized that I had to decide between the Roth IRA and the Traditional IRA.

Having earned less than $10,000 that year, the decision was simple. I simply stuffed as much as possible into the Roth IRA, because most of my income was taxed at 0%.

As I continued learning about this topic, I realized that many media sources recommend the Roth IRA. While the Roth can be an excellent choice, this article will provide a balanced look at both accounts to help you make a more informed decision.

What is a Roth IRA?

Roth IRA accounts are funded with after-tax dollars. There are no tax breaks for contributions made to a Roth account.

However, all earnings inside of a Roth account grow completely tax free, and qualified withdrawals are completely tax free.

As a result, Roth IRA accounts provide the largest benefit for individuals in a low tax bracket.

What is a Traditional IRA?

With the Traditional IRA, contributions are tax deductible in the current year and future withdrawals are taxed as ordinary income.

As earned income rises, the Traditional IRA provides additional tax savings. For example:

  • A couple in the 15% marginal tax bracket contributes a total of $10,000 to a Traditional IRA. They save $1,500 ($10,000*0.15) in taxes.
  • A couple in the 35% marginal tax bracket contributes $10,000, but saves $3,500 in tax dollars ($10,000*0.35)

When the $10,000 mentioned above is withdrawn from a Traditional IRA at retirement, the entire withdrawal is taxed as ordinary income. The tax rate depends on your taxable income at the time of withdrawal.

Which IRA is Optimal?

Conventional wisdom tells us that the decision between Roth and Traditional (true for both IRA and 401k contributions) is based primarily on the following question:

Do you expect to be in a higher tax bracket now or when you start taking withdrawals?

  • If your marginal tax rate is higher in the year of contribution, the Traditional IRA wins.
  • If your marginal tax rate is higher in the year of distribution (withdrawal), the Roth IRA wins.
  • If you marginal tax rate stays the same, you will have the same amount of money in the Roth and Traditional IRA accounts.

But the devil is in the details, and the bullet points above are a bit simplistic for real world application.

In America, we have a progressive income tax structure. As you earn more, your marginal tax rate increases.

  • Your marginal tax rate is the tax paid on your last (or next) dollar earned.

When someone says “I’m in the 15% tax bracket,” they are unknowingly describing their marginal tax rate.

  • Your effective tax rate is the percent of taxes paid over your entire earned income.

Someone in the 15% marginal tax bracket does not pay 15% taxes on all income earned. Some is taxed at 0% courtesy of the standard deduction and personal exemption allowances. Some is taxed at the 10% rate, and the remaining portion is taxed at the 15% marginal rate. The resulting effective tax rate is therefore much lower than the marginal tax rate.

For Example:

Consider a couple (age 30) with no children, earning $50,000 per year. Based on 2017 tax rates, we get the following results:

As you can see, this couple’s effective tax rate is 6.9% ($3,468/$50,000) and their marginal tax rate is 15.0%.

The important thing to understand is that all Traditional IRA contributions are made at your marginal tax rate. If this couple contributes $5,000 each ($10,000 total) to their respective Traditional IRAs, we get the following results: You can see that their tax liability has shrunk by $1,500 exactly, which is equal to their contribution amount multiplied by their marginal tax bracket ($10,000*0.15 = $1,500).

If this couple had opted to contribute the same $10,000 to Roth accounts, they must pay taxes on that money at the marginal rate of 15%. As a result, they would pay $1,500 in taxes ($10,000*0.15) and have $8,500 available to invest. The $8,500 would never be taxed again once inside a Roth IRA.

Fast Forward 35 Years

Assume this couple continues contributing $10,000 in pre-tax ($8,500 after tax) money to their IRAs.

They are now both age 65 and ready to retire. Let’s look at their account balances for both Traditional and Roth:Roth IRA

In this excel sheet, you can see that I have hidden some of the rows for the sake of space. The assumptions include:

  • 35 years of contributions
  • 7.5% annual rate of return
  • 3% annual withdrawal rate
  • All tax laws and tax brackets remain constant.

Tax laws will most likely change, but I can’t predict the future.

As expected, the Traditional IRA has a larger ending balance because the funds inside have never been taxed. The money will be taxed as ordinary income upon withdrawal. The Roth IRA account houses after-tax dollars which will be withdrawn tax free.

Many commentators say that if your marginal tax rate is the same now and in retirement, it won’t matter whether you contribute to the Roth or Traditional IRA. The ending result should be the same.

Assuming a 15% marginal tax bracket throughout this example, does conventional wisdom hold true?

Look at the after-tax withdrawal amount. The answer is clearly no – the Traditional IRA results in nearly $4,000 of additional after-tax income each year.

How Does the Traditional IRA Win?

In the example above, the Traditional IRA provides the most after-tax income in retirement.

In this example, Traditional IRA contributions are made at the marginal tax rate (15%), while withdrawals are taxed at the effective tax rate. This couple has no other sources of retirement income, so the Traditional IRA withdrawals are taxed at a 0% marginal tax rate first, followed by the 10% marginal rate, and so on.

On the other hand, Roth contributions are always taxed at the marginal tax rate in the year contributed (15% in our example). Withdrawals are always tax free.

The elephant in the room is my final assumption – this couple has no other sources of retirement income.

This assumption is highly unlikely. Any additional income streams will result in the Traditional IRA withdrawals being taxed at a higher marginal tax rate, making the Roth more attractive.

I’m not arguing that you should favor either account type, only that you should think about it.

This simple analysis shows that Roth isn’t always the right choice. You shouldn’t listen to anyone who make blanket statements, such as “you should always contribute to a Roth IRA if you have a marginal tax rate of 25% or less.”

Other Important Considerations

Thus far, we have considered one factor – the expected after-tax value of the account.

There are numerous other features unique to each account type that I would like to highlight.

While this makes the decision even more difficult, these unique differences are important in determining which account is right for you.

Reasons to Choose the Roth IRA

Shelter more money this year (behavioral benefit) – If you understand the example above, you might realize that it’s possible to save more for retirement by contributing the maximum amount to the Roth account each year. Instead of contributing $8,500, the couple in the example could have potentially contributed the full $10,000 to the Roth IRA.

For simplicity, let’s now assume that the couple is in the 10% marginal tax bracket throughout life (for all contributions and distributions), the tax advantages are the same for both accounts. However, the funding limits are still in place at $5,500. If the couple funds $5,500 in the Traditional IRA, that money is only worth $4,950 after taxes are paid at withdrawal ($5,500 x 0.9 = $4,950).

If instead, they pay the 10% in taxes upfront and still have enough cash flow to max out the Roth IRA, they are able to effectively save more money. The after-tax $5,500 contributed to a Roth IRA is worth $6,110 pre-tax dollars in the Traditional IRA ($6,110 x 0.9 = $5,500).

This is an important point that most people don’t consider when deciding year end contributions. Many think, “I have $5,500 to invest, where should it go?” In reality, those funds are after-tax dollars sitting in a bank account, and $5,500 in a Roth IRA will always be worth more than $5,500 in a Traditional IRA.

Technically speaking, this example is flawed. If you decide to fund the Traditional IRA with $5,500 and you’re in the 10% tax bracket, your tax savings are $550 in the current year. You could also invest that $550 in a taxable account to grow, but very few people will save that money. In other words, the Roth provides a clear behavioral advantage by allowing you to save more after-tax money each year.

No required minimum distributions (RMDs) – Tax deferred accounts, including Traditional IRAs and 401k plans, are funded with pre-tax dollars. The government has never taxed the funds in these accounts. As such, they require that you take distributions from the accounts beginning at age 70 ½. In doing so, they force you to pay income tax on that money.

Roth IRAs are different altogether. All contributions are made with after-tax dollars. You’ve already paid income tax on the money inside the Roth. All growth is tax-free, and distributions are tax-free. Therefore, there are no required minimum distributions. This can provide a very attractive method of passing wealth to heirs.

Higher income contribution limits – If you participate in a qualified, employer sponsored retirement plan (such as a 401k), there are restrictions on your contributions to an IRA. Traditional IRA contributions are only tax deductible if your income remains below the IRS threshold. The threshold for Roth IRA contributions is roughly twice that of Traditional, meaning higher income earners can contribute more easily to the Roth IRA.

Reduce Social Security taxation – Social Security benefits are sometimes non-taxable, sometimes taxable. Their level of taxability depends on your MAGI, which includes income from Traditional IRA distributions. Above a certain threshold, 50% of benefits are taxed as ordinary income. Above another threshold, 85% of benefits are taxed as ordinary income.

Roth distributions are tax-free. They are not included in the MAGI calculation. Because of this, you can structure withdrawals from Traditional and Roth accounts to minimize Social Security taxation.

Qualify for a healthcare subsidy – The Obamacare subsidy is based on MAGI. Traditional IRA distributions increase your MAGI and might shrink the level of subsidy that you are eligible to receive. By using Roth distributions instead, you can better control your MAGI and the subsidy amount.

Contributions at any age – Any person can open and fund a Roth IRA, regardless of age. You cannot fund a Traditional IRA account after age 70 ½.

Avoid state income tax  If you live in a state that currently has no state income tax, Roth contributions become more attractive. This is particularly true if you want to move to a different state that does impose a state income tax during your retirement years. The Roth contributions have already been taxed and will not be taxable at the state or federal level when withdrawn.

Tax guarantee – In my example above I showed that Roth contributions are taxed at the marginal tax rate in the year contributed, and all qualified withdrawals are tax free. If you are fearful of future tax laws, the Roth allows you to “lock in” your current marginal tax rate.

Flexibility – An investor can withdraw his or her contributions to a Roth IRA at any time without tax or penalty. This is why Roth accounts are sometimes used as an emergency fund.

Reasons to Choose the Traditional IRA

Reduce investment income taxation – Investment income (qualified dividends and long-term capital gains) are taxed at preferential rates. Individuals in the 15% federal income tax bracket or lower do not pay any federal income tax on qualified dividends and long-term capital gains.

Using Traditional IRA (and 401k) contributions, individuals can lower their federal tax bracket in the current year and potentially eliminate taxation on investment income. This is important for those individuals who have lots of realized investment gains, but little earned income.

Future Roth conversions – Barring a few technical rules, you can convert Traditional IRA funds into Roth IRA funds at any time. The amount converted is taxed as ordinary income in the year converted.

There are may situations where a Roth conversion is optimal. Consider a couple in the 15% Federal tax bracket and 6% State income tax bracket. If they choose Roth contributions, they lock in a 21% tax rate. If they choose Traditional, they pay no taxes today. If this couple moves or has a major life event that decreases their earned income, they can pursue Roth conversion at a lower tax rate. That’s more money for them, and less for Uncle Sam.

Avoid state income tax – In our example above, we only considered federal income tax. Most states also collect income tax. Traditional IRA contributions are not taxed at the federal or state level until withdrawn.

For example, consider someone residing in Missouri who is subject to a 6% state income tax. If you contribute to a Traditional IRA while working, and move to Texas or Florida before taking withdrawals (no state income tax), you completely avoid all state income tax. The opposite scenario (moving from Texas to Missouri during retirement) would favor the Roth IRA.

Tax credits – Traditional IRA (and 401k) contributions lower your adjusted gross income (AGI). Roth contributions do not. Many tax deductions and tax credits are based on AGI, such as the Savers creditdependent care credit, etc.

Other credits are based on MAGI. Traditional IRA contributions don’t lower MAGI, but Traditional 401k contributions do. Credits dependent on MAGI include the child tax credit, American opportunity tax credit, and lifetime learning credit.

How About a Little Tax Diversification?

The impossible part of this whole exercise is predicting future income and future tax rates. No one knows where tax rates are headed in the next 10, 20, or 30 years. The whole tax code could be re-written. Furthermore, it’s difficult to predict future income sources in retirement (particularly true for young people).

Because of these facts, The decision between Roth and Traditional IRA involves a significant amount of guesswork. I can’t give you a straightforward answer on the optimal solution for you, but here are a few rough guidelines:

  • If you’re highly paid right now (total marginal tax rate above 30%), choosing Traditional usually makes sense.
  • If your combined (federal and state) marginal tax rate is 15% or below, Roth is tough to beat.
  • Everything in-between depends on your preferences.

While I don’t have any strict guidelines for individuals in the 15-30% marginal tax bracket to follow, I do have a suggestion.

Consider mixing things up over time. You could split your contributions between both account types in any given year. Or, fund one type of account each year and base the decision on your annual earned income.

The optimal outcome is a diversified set of retirement accounts, including tax-deferred accounts (Traditional IRA, 401k, 403b, etc.), tax-free accounts (Roth IRA, Roth 401k, etc.), and taxable accounts. Having different accounts will provide flexibility during retirement, allowing you to structure withdraws from each account to minimize your tax liability in any given year.

Have you made the decision this year? Did you fund a Traditional IRA or Roth IRA?

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29 Comments on "Roth IRA vs. Traditional IRA: The Complete Guide for Wise Investors"

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Joanne Mahoney
Joanne Mahoney

Great article. Even though my taxes are filed for 2016, you’ve given me a lot to think about for 2017. I’m saving this article for my husband to read.

David
David

Thanks. This is probably one of the best article I have read on the issue. I searched around quite a bit. I am curious how much of this is true for the traditional 401K vs roth 401k comparison. Again, Thanks,

David

Kimberly
Kimberly
“Roth accounts are flexible – An investor can withdraw his or her contributions to a Roth IRA at any time without tax or penalty. This is why Roth accounts are sometimes used as an emergency fund.” That is why I just opened a Roth. My husband’s 403b retirement should cover our needs at current funding. We’re lucky to have good contributions from his employer too. But we will have kids in college from 2022-2031. Although they may well be expected to shoulder a good chunk of the responsibility for their education, we want to help as we can. We can… Read more »
Timothy
Timothy
There’s another possible reason an individual might lean toward a Traditional IRA. If you plan to retire overseas, then there are some potential tax effects. In particular, most countries tax worldwide income including investment income, and most countries’ tax codes do not consider U.S. tax-advantaged accounts such as Roth IRAs and Roth 401(k)s to be tax free when making a U.S. qualified withdrawal. There are a few countries that either don’t tax investment income at all (Singapore, UAE) and a couple countries that have tax treaties with the U.S. that protect Roths, but that’s not most countries. However, with a… Read more »
JoeH
JoeH
Thanks Jacob. Appreciate your website and found this post very helpful. I’m close to retirement and was concerned I may have contributed too much to my tax deferred account considering the impact of taxes and RMD. My current marginal tax rate is 30.5% thanks to the feds & state of CT. So at face, it makes sense to fund the 403b with pretax dollars, but with nearly a million in this account I’m considering cutting back on contributions for my remaining years of employment. I have also been funding a Roth for the past six years. When I look at… Read more »
Steve
Steve
Jacob great post. Definitely a chess game of finances. It’s not all simply “do this if you think you’ll make more.” For the final row of the chart though I… after year 35, when owner of Traditional IRA gets ready to take out his money. .. In this example would it be right to say that 15 is the magic number? If you plan on being under 15% tax bracket = Use the Traditional. If you plan on being over 15% tax bracket = Go with the Roth. (Again, estimating as best you can the tax rates 35 years from… Read more »
Jeff
Jeff

Excellent post! I read your blog, and will admit that I almost didn’t read this post thinking it was just another “ROTH vs. Traditional” article. I must say that I was pleasantly surprised. You brought up a lot of points that I’ve honestly never seen brought up in such a post before. Very thorough analysis, much better than I’ve ever seen from a “financial advisor.”

MD
MD

Superb analysis on the eternal question, which one to choose “Traditional or Roth?

The Roamer
The Roamer

Wow that was a long post but thanks so much for writing it.

Did I read that right! A Roth IRA doesn’t have an age limit for pulling out funds?

Isn’t it true only if it has been there 5 yrs. Minimum?

Or is that just for Traditional IRA

Joe Bert
Joe Bert
The real wild card here is that the tax laws remain the same. That’s not a good bet long term. Roth withdrawals are tax free under current law, but so were social security payments at one time. I have two major reservations re the Roth. One is that we don’t have a major tax change, i.e, flat tax, fair tax, value added tax, etc. Second, like SS, the Roths may ultimately be subject to means testing making some of the withdrawals taxable. My advice is if your not in the 10% tax bracket, grab the “bird in the hand” guarantee… Read more »
Kurt
Kurt

You do a great job of running through the math and logic.

For me, this has always been a factor too, though non-quantifiable: Everything else being equal, I prefer to get a known benefit today to an unknown benefit far in the future, even if that future benefit has the potential to be greater. Sort of a variation of the ‘bird in the hand’ think I guess.

Scott Newman
Scott Newman

Excellent breakdown and analysis of Roth versus traditional IRA. The key here as you’ve relayed is for people simply to save, which is a big problem today. I’m a financial advisor with my insurance and mortgage licenses, and would love to hear your thoughts on using indexed universal life as a tax free retirement vehicle. The caveats, of course, are insurability, and willingness to stick to the plan.

Cody
Cody

Very well explained. It’s nice to see someone explain such a complex topic in fairly easy to understand terms. This is definitely where most financial advisers fail. Nicely done.

Michelle
Michelle

I actually just called Fidelity about this. You should train their reps…

nicoleandmaggie
nicoleandmaggie

This is a really fantastic post.

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