To Roth or not to Roth?
Should you use a Traditional IRA or Roth IRA?
The age old question: Should I use a Roth IRA or a Traditional IRA to save for retirement? Assuming you are eligible to contribute to either type of account (please ask your CPA), we will highlight some of the important factors to consider before making a decision. First, lets make sure we understand the main difference between a Traditional IRA and a Roth IRA.
A tax deduction is received when you put money into a Traditional IRA but qualified distributions are fully taxable.
A Roth IRA is just the opposite: you do not get a deduction when you put money into a Roth but qualified distributions are not subject to taxes.
Since the same types of investments can be used in either type of account, we are basically addressing a tax question - is it better to pay taxes now using a Roth, or pay taxes later using a Traditional IRA? In order to answer this question, we have to know what your current tax situation is and what we project it will be in the future.
For example, lets say you’re still working and your current effective tax rate is 30%. During retirement, we project that you will be spending much less than you are making now and will have an effective tax rate of 20%. In this scenario, it may make sense to use a Traditional IRA so we can defer your taxes until retirement - instead of paying 30% in taxes now, you would be paying 20% at a later date - a tax savings of 10%.
On the flip side, lets say you are early in your career and are paying a 20% effective tax. We project that you will do very well financially over the long term and will probably spend a lot of money in retirement. We assume your effective tax rate in retirement will be 30%. In this scenario, it may make more sense to use a Roth IRA and pre-pay your taxes at the lower 20% rate. As your income ramps up and effective tax rate gets above 30%, it may be more beneficial to contribute to a traditional IRA instead.
Impact of Future Tax Laws
Part of this exercise is speculation. What will happen to tax rates in the future? Nobody knows! In 1944-1945, the highest marginal tax rate was 94%!!! If you believe we are headed back in that direction, you may want to pre-pay your taxes now by using a Roth IRA so you don’t have to be subject to the higher rates that you expect to see in the future.
Required Minimum Distributions (RMD’s) with Traditional IRA’s
In the year you turn 70 1/2, the IRS requires that you start taking money out of your Traditional IRA so they can collect the taxes you have been deferring from them. Again, all distributions from a Traditional IRA are taxable when taken. You can run but you can’t hide! If you have a very large IRA balance, your RMD’s may push you into a higher tax bracket and/or impact the taxability of your social security. It’s helpful to note that there are no RMD’s with Roth IRA’s.
No matter how you slice it, the IRA vs. Roth decision can be a complicated one. It’s important to note that this is not an all inclusive summary of the things that should be considered. You should always speak with a CPA and financial advisor to develop a strategy based on your specific situation and financial goals so you can make an informed decision. Please contact me with any questions or if you would like to discuss your options in greater detail.