As an investor, your goal is to invest in a way that gives you the highest after-tax return on your money.
You can do this in one of two ways:
- Asset Allocation: The types of investments you choose (stocks, bonds, dividend stocks, etc…)
- Asset Location: The types of accounts you invest in (Traditional or Roth IRA, 401K, taxable account etc…).
Choosing between a Traditional vs. a Roth IRA is a choice of asset location.
One type of IRA isn’t better than the other. It’s your situation that determines the account that will optimize your after-tax return.
The advice I find online on this topic, are statements like, “If your tax bracket will be higher now than in retirement, invest in a Traditional IRA.”
This can be good advice.
But to get the right answer, there’s a lot more you must know.
It’s worth mentioning, this is an important decision. Deciding between the right account today will impact the quality of your life in years to come.
This article will discuss:
- The difference between a Roth vs. Traditional IRA
- Knowing your marginal tax rate & why it matters
- Understanding the impact of IRA required minimum distributions
- The difference in Roth & Traditional IRA contribution limits
- General guidelines for who should choose a Roth IRA
- General guidelines for who should choose a Traditional IRA
- General guidelines for investing in both a Traditional & Roth IRA
Part #1: Which IRA Is Best For You?
The primary difference between a Traditional vs. Roth IRA is in the taxation benefits.
- Traditional IRA – Contributions are tax-deductible and taxes are deferred until withdrawn.
- Roth IRA – Contributions are not deductible but withdrawals are tax-free.
But that’s just the beginning.
Here’s what else you need to know, which may impact your decision:
- Age Requirements
- Traditional: Must be under the age of 70 1/2 with employment income
- Roth: Anyone can contribute as long as they have employment income
- 2019 Contribution Limits
- Traditional: $6,000; $7,000, if age 50 or older
- Roth: $6,000; $7,000, if age 50 or older
- Income Requirements
- Traditional: As long as you have employment income, you’re eligible to contribute. Tax deductibility depends on your income and participation in an employer plan.
- Roth: Income limits do apply.
- Qualified Withdrawals
- Traditional: Contributions and earnings are taxed as ordinary income at the time of withdrawal.
- Roth: You can withdraw contributions and earnings tax-free after age 59 1/2.
- Non-Qualified Withdrawals
- Traditional: The entire amount of your withdrawal is subject to a 10% penalty
- Roth: You can withdraw contributions tax and penalty free before age 59 1/2. Earnings that withdrawn before the age 59 1/2, are charged a 10% penalty. Exceptions do apply.
- Minimum required distributions (MRDs)
- Traditional: Minimum required distributions starting at 70½
- Roth: Withdrawals are not required during your lifetime
- What is a qualified withdrawal? – If you’re over the age of 59 1/2, you may withdraw any amount from a Traditional IRA penalty-free. You can withdraw penalty free from a Roth IRA after the age of 59 1/2, as long as the account has been open 5 years. There are special exemption to avoid penalties.
Factor #1: Marginal Tax Rate vs. Tax Bracket
When it comes to choosing the right IRA, the #1 factor is comparing your current vs. future tax rates.
Your goal is to pay taxes, at the lowest possible rate. That’s why you hear the advice:
- If your tax rates today are lower than they will be at the time of withdrawal, choose a Roth IRA
- If your tax rates today are higher than they will be at the time of withdrawal, choose a Traditional IRA
And this is true.
But, there’s a common mistake that’s often made.
To understand what you’re taxed today, you must know your marginal tax rate. Your marginal tax rate is the tax rate applied to the next $1 of income.
For example, say your federal tax bracket is 25%, your state tax bracket is 5% (forgetting to include state taxes is mistake # 2).
To keep things simple, you take the standard deduction and are not affected by any credits, phase-outs, etc..
In this scenario, an extra $1 of income would have a marginal tax rate of 30%.
The easiest way to understand your marginal tax rate is to use tax software. (You don’t have to buy the software unless you file)
You can add $1,000 to your income and see the impact. If you’re considering investing in a Traditional IRA, deduct $1,000 to measure impact.
It can be more complicated once you add in income phaseouts, credits, etc… But, the above will allow you to have to have a close estimate of your marginal tax rate.
- You lose a lot of tax credits as you retire. You don’t want to over save in tax-deferred accounts. Not as many tax credits. You will lose child credits. Your mortgage may be paid off. Etc..
- If you plan to pass on your IRA, you must factor in the marginal tax rate of the beneficiary. You want to look at your current marginal tax rate compared to the expected marginal tax rate of the beneficiary.
Factor #2: IRA Required Minimum Distributions
Comparing current and future marginal tax rates is the primary factor in choosing the IRA with the highest after-tax return.
Income taxes, unfortunately, are not the only taxes associated with an IRA account.
Traditional IRAs are subject to required minimum distributions (RMDs).
Roth IRA accounts do not have RMDs.
RMDs is a tax law which requires you to withdraw a certain amount of your Traditional IRA each year.
RMDs start at the age 70 1/2.
This is a disadvantage for those;
- Who plan to work past the age of 70 and thus will maintain a higher marginal tax rate
- Who want to pass on their IRA to a beneficiary
Factor #3: The Difference in Roth & Traditional IRA Contribution Limits
In 2019, Roth and Traditional IRAs have the same maximum contribution limits.
You can contribute:
- Traditional: $6,00; $7,000, if age 50 or older
- Roth:$6,00; $7,000,, if age 50 or older
What’s important to understand is that $6,000 in a Roth IRA isn’t equal to $6,000 in a Traditional IRA.
In a Traditional IRA a part of your account belongs to the IRS.
If you expect to pay 15% tax on your withdrawals, 15% belongs to the IRS.
In a Roth IRA, 100% is yours to keep.
The contribution limit is, therefore, higher for Roth IRAs.
This comes into play for those wanting to max out their IRAs but still have money in taxable investment accounts.
All things being equal, it’s better to invest 100% in a Roth IRA, then say 85% in a Traditional and 15% in a taxable account.
This is another advantage for Roth IRAs.
Related reading: If you’ve maxed out your contributions, you should also consider using a Health Savings Account, which offers an opportunity for $3,5000 per year in additional tax-advantaged saving and investing. You can read more about HSAs in my detailed review of Lively, a no-fee HSA provider.
Part #2: Guidelines for Choosing a Roth or Traditional IRA
The factors that determine which account will provide you the highest after-tax return are:
- Current vs. Future marginal tax rates
- The impact of RMDs
- If you’re maxing out contributions in all tax-deferred accounts, leaving you only taxable accounts to invest in
With this in mind, now let’s look at some general guidelines for choosing an IRA.
General Guidelines For Investing in a Roth IRA
When does paying taxes now, via investing in a Roth, make more sense than deferring taxes?
Let’s look a few common scenarios:
- If your current marginal tax rate is 15% or less
- If you expect to have a higher marginal tax rate in the future
- If you expect to have the same or higher marginal tax rate as you do now after the age of 70.5
- If you’re maxing out contributions in all available tax-deferred accounts, leaving you only taxable accounts to invest in
General Guidelines for Choosing a Traditional IRA
When does deferring tax, via investing in a Traditional IRA, make more sense?
When you expect your tax rates (or tax rate of the beneficiary) to be lower at the time of withdrawal
General Guidelines for Choosing Splitting Contributions
The further you’re away from withdrawing from your IRA, the harder it to predict your future tax rate.
Not only is it hard to predict what your life will be like, but it’s also not possible to predict what the Government will do.
- Tax rates may increase.
- Roth IRAs may lose some of their benefits
- Estate taxes may change
- Social security income may change
You get the idea. There’s no shortage of variables outside of your control.
That’s why it may make sense to invest in both a Roth and Traditional IRA.
You’re allowed to split your contributions between both a Roth and Traditional IRA.
By doing so, you’re essentially hedging your tax situation. This makes sense for those who it is very difficult to predict their future tax situation.
What to Do if You’re Still Not Sure
A financial planner can help you evaluate your situation and make the right call, and there are many free (or very low-cost) resources available. You can learn how to find them in this guide.