More on Traditional IRAs Versus Roth IRAs

So, the question remains as to which is better: a traditional IRA or a Roth IRA. The former gives you a tax break this year and tax-deferred earnings, but taxes you at withdrawal. The latter doesn't give you anything now (you contribute with post-tax money) but earnings are tax free. The correct answer seems to depend on a couple factors: 1) your specific situation and 2) what tax rates will be in the future. It's likely that point #1 can be of some help, but we're all merely guessing at point #2. The general thinking is that tax rates as a whole will likely be higher when we all retire, but that we'll also be in lower tax brackets then too (since we'll earn less.)

So with everything clear as mud, I thought I'd post two (somewhat) different viewpoints on the issue that were listed as comments to my post titled Retirement Smackdown: Which is Better -- Traditional IRA or Roth IRA? First, here's a comment favoring the traditional IRA:

The vast majority of people will be in lower tax brackets at retirement so would do better with a Traditional. They are, however, the ones that likely aren't saving anyway, so those that are saving may well prefer a Roth.

This (at least the first part) is what my line of thinking has been recently as well. But then, we had this comment:

One more thing to add. The assumption that your income tax rate will be lower in retirement is really faulty. I am a CPA so let me show why.

1 - Incomes tax rates are at historic lows right now

2 - Things people don't consider in retirement that I see with my clients all the time - you will likely be single (widowed or divorced) much of retirement, which today would mean if you had 1/2 the income you had as married you'd still be in the same tax bracket. You brush up against the next higher tax bracket a LOT sooner when you are single. That's unique to today since the marriage penalty was removed though, and will probably be back soon enough. Hard to explain, but makes a difference for now, maybe not for the long-term.

More importantly, in retirement you expect to make a lot less money, but you also lose most of your tax deductions. Just because your income is lower does not mean your taxable income is lower... Most of my six-figure working clients with families are in the 15% tax bracket these days while most my $50k/year retiree clients (most who are divorced or widowed) are in the 25% bracket. The difference is simply the amount of tax deductions.

So the real answer is still somewhat unclear. Could it be that they are equally good based on the fact that we can't accurately predict taxes?

For some additional thoughts on this topic, see these links:

• Roth IRA Versus 401k -- Which is Better?

• How to Maximize Your Retirement Savings

• Save a Little Bit a Day and Become Rich

Comments

[Dunadyne]

Opt for tax-diversity--contribute to both. It seems a lot like guessing to me. Factor in that long-term capital gains (taxable) rates are low, low too, and the picture is even muddier.

[Mike]

I agree with the tax diversity. I asked a CPA on this one as well and I felt that his answer was very good. He said he had worked back in the 1970's when the marginal tax rate was 70% and everyone thought it was going up. If Roths had existed then high income people would have been screwed even though they were listening to sound advice. He mentioned that a bird in the hand is better than two in the bush, basically take the tax break now instead of trying to game the system, because congress could very well repeal Roth tax free status later anyway.
With that being said, I am just starting my career so I want to take advantage of this. My company offers a Roth 401k, but our match is a normal 401k match. This is perfect for me, because it basically splits me between the two theories effortlessly.

[KMC]

Two things - I don't think there's much question that if you're asking this question, (1)you're saving for retirement and will therefore likely have at least decent assets and income at retirement and (2)tax rates have nowhere to go but up. The U.S. has unfunded liabilities estimated between $50 trillion and $80 trillion. That's money that someone's going to have to pay...in taxes.

Second, tax diversification is an important planning tool many people overlook. Diversification isn't only for your asset classes.

[broknowrchlatr]

Its a complicated calculation, but I'll add my info.

I earn X and want to have retirement income of about 81% of X. I think this is pretty typical. But, I have 2 kids, full 401k contributions, and about $7k a year in mortgage interest.

So, my current taxable income is quite a bit less than it will be in retirement. That, and the fact that I am concerned about tax rates increasing, I'm getting as much of my savings ROTH-ified as I can.

[Phil]

I agree with the first comment and the last line in FMF's post. Invest in both to hedge against what a future congress will do. Although uncommon, congress has passed laws that *retroactively* change tax rules (upping the age of the kiddie tax from 14 to 18 comes to mind); so tax planning where you don't reap the benefits decades later carries some risk. Investing in the trad IRA gives you an immediate benefit that you can turn around and invest in the Roth correct?

In my situation, my spouse is a homemaker and we're in the middle of the 28% bracket. Investing up to the max deduction in trad IRA ($4000 for 2006) gave us an extra $1000+ (from the tax deduction) to invest in a Roth.

[Blaine Moore (Run to Win)]

Phil, that's a great strategy!

[Lord]

If you are in a tax bracket below 25%, you most certainly will be in a higher one in retirement or you won't retire at all. If you are above 28%, you will very likely be in a lower one in retirement or have so much money you shouldn't worry about taxes. If you can estimate what your expenses will be in retirement, you can estimate whether that is likely to be a higher or lower bracket. If you will be out of debt and own your home, it will likely be lower or you really are saving too much for retirement. If your expenses will continue to rise with or faster than inflation and your deductions go away, it will likely be higher.