What kind of IRA should I invest in – Roth or traditional?
Seven words provide an answer: Pay taxes now or pay them later.
Your investment in either a traditional IRA or a Roth IRA benefits from tax-deferred growth, but the difference is when you give the government its due. In a traditional IRA, your contribution is considered to be before taxes. One day, after your money has grown (hopefully substantially), you get to give a portion of it to the government as taxes upon withdrawal. With a Roth IRA, your contribution is considered after taxes because you do not get a tax deduction on your contribution.
When discussing the trade-offs between Roth IRA vs traditional IRA among people my age, many already know the pre-tax vs post-tax difference. What they want to know is the benefit or the value of doing Roth instead of traditional. With that in mind, I’d like to address a few common questions the answers to which help explain a Roth IRA’s value:
1) What if tax rates change in the future?
This is where we have been able to run various calculations on the benefits of the Roth IRA, assuming you have the discipline to defer benefits, the years to grow the investment, and don’t need the immediate tax benefit.
If your tax rate remains the same or goes up in retirement, the Roth IRA is a better choice since you get to take your money out tax-free compared to paying that same or higher tax rate on appreciated assets in a traditional IRA. In some cases though, even if you are in a lower tax bracket, the Roth IRA could win out with enough time on your side.
But wait! That’s not entirely accurate, what about inflation!? Good point, and a fair one too. We were sure to take inflation into account. Even after discounting future tax payments from a traditional IRA distribution back into today’s dollars, it often comes out more expensive than just paying taxes up-front in a Roth IRA. Who knows where tax law will be in the future, but nonetheless, the message is: If you are in a higher or similar tax rate in retirement, numerically Roth IRA makes sense, and with enough growth and time on your side, it can even make sense if you end up in a lower tax bracket.
2) Any other benefits?
I’m glad you asked. You may or may not know that when you reach 70 ½, with a traditional IRA, you are forced to take out required minimum distributions. The government gives you a tax break while you are investing in the traditional IRA, so they are going to be sure to get that money back eventually and that’s basically what this distribution is. With a Roth IRA, since you paid the taxes upfront, there is no required distribution during your lifetime. This is excellent if you have other assets you can count on and just let the Roth IRA continue to grow. This makes it a versatile investment as you can use it when you see fit, or even leave it as a great tax-free inheritance to your heirs.
Peace of mind. This is a personal one, but I know friends of mine share this sentiment. What will my tax rate be in retirement? What will the tax law be in 30 years? How much will I have when I finally stop working? How much will my investments grow? I don’t have the answers to these questions. I have an idea of what I’d like, but much will change between now and that day. I find relief in knowing I paid the taxes, got it over with, and when I take money out in the future, that’s the amount that’s going to the bank. It is one piece of certainty on a long road ahead with much uncertainty.
3) What about my 401(k)?
Many plans these days offer a Roth 401(k) option. If you aren’t sure if your plan allows for this, you definitely want to check. The ability to put up to $18,500 away annually in a Roth account is an amazing benefit that you should consider doing along with maxing out your Roth IRA (assuming your income doesn’t make you ineligible to contribute). A great benefit of the Roth 401(k) is, unlike a Roth IRA, you can make contributions to a Roth 401(k) regardless of your income.
Everyone’s situation is different and there may be good reasons for young investors to choose a traditional IRA over a Roth IRA. Overall though, given the future tax benefit, time on my side, flexibility of the investment, and peace of mind it provides me, I know what strategy I will be using for a long time to come.
Disclaimer: The information provided here is general and intended as educational in nature. It is not intended nor should it be considered as tax, accounting, or legal advice. Investec Wealth Strategies and its advisors do not provide tax, accounting, or legal advice. We recommend you seek the counsel of your attorney, accountant or other qualified tax advisor concerning your situation.