I once heard a financial professional say to a small audience, “You don’t have to pay taxes on withdrawals made from a Roth IRA, so I don’t know why anyone opens Traditional IRAs.” I cringed when I heard this because I could think of dozens of scenarios where a Traditional IRA might outshine a Roth. Determining which type of IRA is best for you requires a thorough look at the differences between each.
The biggest difference is when you pay your taxes. With a Roth, you invest after-tax income (non-deductible contributions) into your retirement plan, but you don’t pay taxes on qualifying withdrawals, meaning you essentially pay your taxes up front. With a Traditional IRA, your contributions into your IRA are tax-deductible (there are exceptions), but you get taxed when you make withdrawals from the account, meaning you pay your taxes in retirement. Using this distinction alone, you should contribute a Roth IRA if you expect your marginal tax rate to be higher in retirement than it is now, and you should contribute a Traditional IRA if you expect your tax rate to be lower in retirement than it is now.
It can be difficult to predict what your tax rate will be during your retirement years, which is why I like the more simplistic rule that Jim Cramer from Mad Money uses. His rule says if your current tax rate is less than 25%, open a Roth, otherwise open a Traditional IRA. You can determine your current marginal tax bracket using the handy charts at Bankrate.com.
Where this decision gets more complicated is when you consider other differences between the two types of accounts. Are you likely to make a nonqualified withdrawal before age 59½ ? If so, you’ll probably be better off with a Roth because contributions (principal, not earnings) can be withdrawn without paying an IRS premature distribution penalty. With a Traditional IRA, the IRS will penalize you with a 10% early withdrawal fee (unless an exception applies) as well as charge you taxes.
Are you likely to work well into your retirement years and hope the account will be more for your heirs than yourself? If so, again it’ll probably be better to use a Roth IRA because it doesn’t have required minimum distribution rules and you’re even allowed to continue contributing to it beyond age 70½.
Are you hoping to give a lot to charity in your retirement years? In that case, a Traditional IRA may be a better option because of the qualified charitable distributions rule. When you are at least 70½, you can donate your required minimum distribution directly to a charity, and then exclude it (not deduct it) from your income on your tax return with a Traditional IRA. This means you never get taxed on the money, which is pretty amazing.
Remember all of this the next time someone tells you to invest into a Roth IRA because “it’s tax free!” I’m misquoting a joke by my favorite financial author Jeff Yeager, but the same people that tell you a Roth is completely tax free may also warn you not to even invest in an IRA because they “don’t believe in an independent Northern Ireland.”
Please consult your tax advisor for advice regarding your specific tax consequences.
By Adam Lucas Adam Lucas holds a Finance degree and an MBA from the University of Kentucky. His work has appeared in many major outlets including Yahoo, AARP.org, and GoBankingRates.com.
Monday on the Money is a weekly commentary from Bank of the Ozarks providing financial advice and solutions important to you and your family.