If you have money to save in an IRA, should you do so using a Roth IRA or a traditional IRA? Here are factors to consider to arrive at the best decision. You'll see that a Roth IRA is likely to be the best deal for a great many -- but not in every case...
they start out equal
A traditional IRA provides a deduction on contributions, but distributions from it are taxable as ordinary income.
A Roth IRA provides no deduction on contributions, but distributions after retirement age can be totally tax free.
In a hypothetical world, when "all other things are equal," these two arrangements are exactly equivalent, giving the same after-tax value to retirement savings in the end.
Example: A person in the 25% tax bracket today earns $100 that he uses to fund an IRA contribution. It earns a 7% return for 20 years, and then it and the compound earnings on it are distributed while the individual is still in the 25% tax bracket. With a...
Traditional IRA, the full $100 is contributed to the IRA (unreduced because of its deductibility), then grows over 20 years to $387 -- which, after 25% tax on distribution, leaves $290.
Roth IRA, the initial $100 is reduced by 25% tax, leaving $75 to put in the IRA, which grows over 20 years to $290 tax free.
So with all other things equal, the traditional and Roth IRA give the same result. But in reality, it's very unlikely that all other things will be equal.
Expected changes in your future tax bracket can make either kind of IRA more attractive than the other. With a...
Traditional IRA, if one is in a higher tax bracket when deductible contributions are made than when taxable withdrawals are taken, one saves tax-wise. But if one is in a higher bracket when withdrawals are taken, one loses tax-wise.
Roth IRA, it's the reverse -- the advantage accrues to one who is in a lower tax bracket when contributions are made than when withdrawals are taken.
Thus, Roth IRAs are generally advantageous for children and persons in their low-tax-bracket, early earnings years, who expect to be in a higher tax bracket later in life.
Example: A young person in a 15% tax bracket who funds a Roth IRA can withdraw funds later in life (after age 59½) tax free, even when he/she may be in a much higher tax bracket.
Traditional IRA planning: Most people in their high earnings years may expect to be in a lower tax bracket after retirement -- an argument for the traditional IRA. But...
Not everyone expects to be in a lower bracket after retirement, even under current law.
Today's tax brackets are at historic lows, especially for higher earners. With massive budget deficits projected in the future due to Medicare and Social Security costs, tax bracket rates may well go up in the future, to the detriment of holders of traditional IRAs.
Other differences that favor Roth IRAs...
Contribution rules. These are more liberal for Roth IRAs.
A person who is a participant in an employer's qualified retirement plan can make a deductible maximum contribution to a traditional IRA only if modified adjusted gross income (MAGI) is less than $50,000 on a single return or $75,000 on a joint return for 2006 (with the deduction completely phased out as MAGI rises to $60,000 and $85,000, respectively). But the "covered by an employer plan" limitation doesn't apply to Roth IRAs, and anyone with MAGI as large as $150,000 (there is a phaseout at $160,000) can make a maximum Roth contribution.
For persons not covered by an employer plan, there are no income limits for traditional IRAs, but the Roth limits continue to apply.
Minimum annual distributions. With a traditional IRA, after reaching age 70½, annual distributions become mandatory, with the amounts based on life expectancy. If you don't really need the money to live on, this forces taxation on unwanted distributions at top rates.
No minimum distribution requirement applies to Roth IRAs. Thus, you can leave funds in them as long as you desire to receive additional tax-free compound investment returns.
Bequest possibilities. Because of the lack of any lifetime minimum required distributions, one can plan to leave a Roth IRA to children or grandchildren who then may receive totally tax-free income from it at any age over their entire lives. Even a small amount left in such a Roth to compound over such a long time -- perhaps several decades -- may provide huge total returns to the children.
In contrast, predeath mandatory annual required distributions from traditional IRAs reduce amounts that can be left to children through them -- and if a traditional IRA is left to heirs, it will pay distributions that are taxable to them at top ordinary rates.
Long-term capital gains and dividends. In a taxable account, long-term capital gains and qualified stock dividends are taxed at a top rate of 15%.
In contrast, if you hold stocks for long-term gains and dividends in a...
Traditional IRA, it will increase the tax rate paid on capital gains and dividends to top ordinary rates.
Roth IRA, it will reduce the tax rate due on them to 0%.
Early withdrawals. Distributions taken out of a traditional IRA funded with deductible contributions are subject not only to income tax, but also to a 10% penalty if withdrawn before age 59½.
But contributions made to a Roth IRA can be withdrawn at any time tax free and without penalty -- only earnings on contributions are subject to penalty if withdrawn prematurely.
Moreover, withdrawals from Roth IRAs are deemed to be made up of contributions first, until all are withdrawn.
Result: A Roth IRA can serve as a tax-free source of funds at any time before retirement if necessary.
Note: When a traditional IRA is converted to a Roth IRA, the converted amount can be withdrawn without penalty after five years.