Why Money Magazine Thinks a Roth Beats a Traditional IRA

Since we've been going back and forth quite a bit about the value of a Roth IRA versus a traditional IRA (see these posts for details: Retirement Smackdown: Which is Better -- Traditional IRA or Roth IRA?, More on Traditional IRA Versus Roth IRA, More on Traditional IRAs Versus Roth IRAs) I thought it would be interesting to share a view from Money magazine. They think the Roth is the best way to go for one simple reason: you'll end up with more money in the long run. They do some math to back up their findings, but here's the bottom line:

When you're contributing the max, the Roth has the distinct edge since more of your money grows without the drag of taxes. The advantage is sometimes so large that a Roth remains the better option even if you move to a slightly lower bracket in retirement.

They also address the tax issue. Most financial advice says that if you expect your taxes to go down in retirement, go with a traditional IRA. If you think they'll go up, go with a Roth. Here's what Money has to say:

You can't really count on your tax rates dropping in retirement. If you travel a lot or live a particularly comfy lifestyle, your withdrawals from retirement accounts could easily be high enough to keep you in the same bracket that you're in now or knock you into a higher one.

Another tax wild card: Congress. Given the size of the budget deficit, it's hardly a stretch to imagine that future legislators might raise tax rates, which could sharply reduce the after-tax value of the money you have stashed in traditional IRAs and 401(k)s.

By funding a Roth, you hedge against the possibility of higher rates by ensuring you'll have some savings that won't be subject to income taxes at all.

Roths have another nifty advantage. With a regular IRA, you have to take distributions after age 70½. Roths have no such rules, which means you can let your entire balance grow without taxes for the rest of your life if you wish - and pass on the tax-free gravy train to heirs.

They make a pretty compelling argument, don't you agree?

I'm still in the tax diversification camp -- the one that says some of your money should be in tax-free accounts (like the Roth) and some in tax-deferred accounts (like the traditional IRA.) Then again, for those of you who don't qualify for a Roth, the choice is made for you (until 2010 that is -- the year you can convert your traditional IRAs into Roth IRAs.)

Comments

[Lord]

This does stress one of the other exaggerations made in favor of the Roth, the ability to avoid taxes. If you invest directly or in low cost index funds, dividends and capital gains are minimal or can be made minimal until you ever sell, and both these are much less heavily taxed than income. You could really be doing yourself a disservice if you lock up too much in retirement accounts when such fruitful opportunities lie outside of them. The real competition for the Roth is not the Traditional but the

As far as tax rates go, if you are in the lowest ones expect them to go up, if you are already in the top ones, it is a bit foolish to base your decision on whether they might increase in the future. The Roth could come under attack as easily as anything else.

[limeade]

I'm a big fan of the Roth IRA. You're also always able to pull out any contributions at any time without penalty since they've already been taxed.

-limeade

[EMF]

These are among the reasons I'm converting tax-deferred savings to Roth. Converted $13K last year, plan to do about the same this year.

However, for the average boomer nearing retirement with next-to-nothing saved up, I recommend putting all your contributions into tax-deferred savings. The standard deduction and personal exemption adds up to $8750 of adjusted gross income before you pay any income tax. While the feds will probably increase the marginal rates, I doubt they'll take away personal exemptions or standard deduction. For those over 65 the $8750 increases to $9800. If you have $150K of tax-deferred savings and spread it evenly out over 15 years of retirement, you'll pay hardly any income taxes on it. And a married couple would double that amount.