More on Traditional IRA Versus Roth IRA

I had a good comment to my post titled Retirement Smackdown: Which is Better -- Traditional IRA or Roth IRA? that I thought was worth sharing with all of you:

There are three advantages of the Traditional IRA that are not usually mentioned by financial planners, most of whom seen to promote the ROTH as always superior.

1. If you build up years' worth of contributions in a traditional and then one year decide that the ROTH would be now more appropriate, you can convert amounts from the traditional to the ROTH. However you can't do the same with the ROTH. If you make nothing but ROTH contributions for many years you can't suddenly convert those prior year contributions into a traditional IRA.

2.Traditional IRAs are often more favorable from a state income tax perspective. In Michigan for example your traditional IRA contributions decrease your taxable income in the year you contribute and once you hit 60 years old your distributions are not taxed. ROTH IRA contributions will not lower your taxable income. Thus you get tax benefits twice with the traditional versus only once with the ROTH.

Also many people have to live in high tax states like Ohio during their working years because they are tied down to a particular job but in retirement they can be much more flexible about where they live and move to a state with low or no income taxes like Florida. Such people would benefit more from a traditional IRA because they would avoid tax on both the contributions and withdrawals.

3.Traditional IRAs give you a tax deduction now. Congress can't decide years later to retroactively eliminate this deduction. However ROTH IRAs only give you hypothetical tax benefits years into the future. If the ROTH IRA fell out of favor with lawmakers, your ability to take tax free distributions from your ROTH could come to an end. Former Democratic leader Dick Gephardt is one prominent example of a politician who hates the ROTH and wants to see it eliminated.

The main advantage I see with the ROTH is the ability to take out contributions tax and penalty free during your working years. This makes the ROTH a good hidden emergency fund. For several years in my early twenties I contributed to a ROTH for this reason. Now that I have a comfortable savings cushion and a higher income I am going the traditional route.

So sometimes the ROTH is better and sometimes the traditional is better. There is no one size fits all answer.

I used to think that in almost all cases the Roth was the preferred option, but I think I'm now leaning towards the position that these two are a wash (either is equally good) unless you have a specific financial situation that tilts the odds in favors of one of them.

Any other thoughts on this?

Comments

[Brad]

To me one of the biggest Roth advantages is that the contribution limit allows you to build a lot more money in your Roth IRA than you could in a traditional IRA. The same goes for a Roth 401k, which my employer has started to offer.

I am for tax diversification. I like the Roth better for several reasons but as you mentioned, we can't be guaranteed that the tax benefit will remain by the time we withdraw. I'm going to shoot for evening out the two tax situations if I can, to help mitigate the potential effect of future Roth taxation.

[A Tentative Personal Finance Blog]

Any advice for a household that makes 100K a year and expects to be making a lot more in the future? We don't have a 401K yet, because we haven't been working in our jobs long enough. Right now, we're socking money into a Roth IRA and I was wonder if I should haven't just opened a Traditional instead.

[broknowrchlatr]

These are interesting points.

#1-not true. You can "re-characterize" a ROTH (or part of one) into a non ROTH IRA. You can then deduct that amount from your taxable income. You could actually switch back and forth a few times. The only stipulation is that you can't do a non-ROTH to ROTH conversion and then a recharictarization within 12 months (you could kind of cheat on your taxes if you did).

http://www.investopedia.com/articles/retirement/03/092403.asp

#2 true - in Michagan, a standard IRA is better by far.

#3 The law that enabled ROTHs made them permanently tax-free at retirment. A repeal of this disabled FUTURE roth contributions, but does not affect current funds. I think it is a bigger concern that the tax rates will increase and a non-ROTH IRA will be taxed more heavily in the future than ROTH funds are taxed now. After all, how is the Social Security bail out going to happen without raising taxes.

@ Tentative. Get as moth as you can in ROTH now. Then when you make mroe money, you can either keep that in the ROTH or recharacterize it. The benefit of the latter is that you might be paying 15% on the money you put in now, but you could get a 25% decrease in taxes once your income gets higher.

[A Tentative Personal Finance Blog]

Thanks for the advice. My wife and I are maxing out both of our accounts. Next year, we'll be contributing to get our full company matches and I hope we can still max out our Roths. It might be a stretch though.

Thanks for some insight!

[Tim]

broknowrchlater: there are a couple of clarifications that you may have missed or did not include in your comments about recharacterization. recharacterization can only occur in the same tax year. If you made a bunch of RIRA contributions in the past, you cannot recharacterize them to a TIRA now. second, you erred when stating you cannot recharacterize a TIRA to RIRA conversion in the same year (within 12months). On the contrary, if you convert TIRA to RIRA and determine that your income is higher than the limit for doing a conversion, you must recharacterize else face steep penalties. second, if you convert from TIRA to RIRA and determine that your RIRA has not increased in value, then it is beneficial to recharacterize to TIRA so you aren't paying taxes on something that is worth less.

Caveat on TIRA to RIRA conversion, is that there are income limitations to doing so.

A Tentative Personal Finance Blog: If your income is $100k now, I would recommend RIRA rather than TIRA since your income is going to be increasing a lot more in the future. If your income exceeds the income limitations for converting, you will not, as of now, be able to convert your TIRA into RIRA if your income increases a lot more in the future. however, if your 401k contributions are such that they lower your MAGI to within the income limitations, then you could consider TIRA.

the biggest benefit of RIRA, and why people push it, is the tax-free benefit. you may not be able to get a tax deduction or tax credit on your TIRA given your income level.

the caveat with the TIRA even in Michigan, is that even though you may not have to pay "state" tax on distributions, they are still subject to federal taxes. You can do the calculations, but you cannot forget to include both federal and state tax issues when determining if TIRA and RIRA are worth it. In general, RIRA, within the AGI constraints, will be better. again, there isn't a one size fits all.

[Aaron]

Why not contribute to both?