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Roth IRA or Traditional IRA?

Roth IRA or Traditional IRA?

February 06, 2024

Should you invest in a tax-exempt (eg. Roth IRA) or tax-deferred (eg. Traditional IRA) retirement account?

In my last blog post, I went over the differences between active and passive investing. This week I will continue my "debate series" by going over another decision that many agonize over; choosing whether to invest in a Roth account or a traditional account. Essentially what you are deciding between when choosing a tax-deferred plan or a tax-exempt plan is when you want to pay your taxes. There is no tax-free investment (except HSAs but they have limitations) but there are still major tax advantages when it comes to investing in retirement accounts.

A tax-deferred account can be a 401(k), traditional IRA, SEP IRA, Simple IRA, 403(b), 457, or a few others. For these accounts, you don't pay any taxes now when you contribute but do pay taxes when you take the money out in retirement. Anything you take out in retirement is taxed as income, no different than how your paycheck is taxed. If this is confusing, think of withdrawing money from your retirement as being the same as money you make from your employer in terms of how it is taxed.  

A tax-exempt account is basically anything with "Roth" in the name such as a Roth 401(k), Roth IRA, etc. The money that you contribute to these accounts is taxed before you put it in. Your employer pays you a salary, the government takes their share while laughing maniacally (that is how I envision it), and then you move it into your retirement account. From there, you invest the money into a strategy that suits your goals and risk level to grow it for retirement. The major benefit of Roth accounts is that you do not pay taxes on any of your earnings so long as you follow the stipulations for them (more on that in a second). 

Tax Deferred Account Pros & Cons

Pros

Tax Deduction Now

If you are in the prime earning years of your life, you are likely in a higher tax bracket. I would hazard a bet that seeing less of your money being taken out in taxes and more in your retirement account would bring you some amount of joy. Contributing to a tax-deferred account allows this so you can wait to pay taxes on this money until you are retired and likely in a lower tax bracket. 

Cons

No Early Withdrawals

Once you contribute to a tax-deferred account like a 401(k), you likely will need to wait until you are 59 1/2 to take withdrawals or else you will pay income tax plus an additional 10% penalty. There are special circumstances where you can pull from your account penalty-free, though you will still pay income tax on the amount. You can find the full list here but these are the most common I see:

  • distributions up to $5,000 per child for qualified birth or adoption expenses
  • up to $10,000 to help with the purchase of your first home
  • up to $5,000 for birth or adoption expenses
  • total and permanent disability of the participant/IRA owner
  • Rule of 55: you retire from your current employer during or after the year you turn 55 (age 50 for public safety employees of a state, or political subdivision of a state, in a governmental defined benefit or defined contribution plan). This only pertains to your current employer's 401(k) plan, not to any previous plans or IRAs. 
  • distributions made to a terminally ill employee, on or after the date the employee has been certified by a physician as having a terminal illness

*Please be aware that by pulling early from your 401(k) you are giving up all future gains you would have for your retirement. You could be giving up years of retirement by making this decision so please give it some thought before going through with it. 

Early Withdrawal Penalty

If you take money out of your tax-deferred account before you are 59 1/2 and do not meet one of these criteria, you will be subject to not only paying income tax on this money but an additional 10% tax penalty. This is a big deal. If you are in the 22% tax bracket and take out $10,000 early you would be paying $3,200 (22% + 10% penalty = 33%) in taxes, nearly a third. 

Required Minimum Distributions (RMDs)

The government likes getting tax money. I think we can all agree on that. Tax-deferred accounts are one of the few ways to put off having to pay taxes to the government. While they are fine with this, eventually their patience wears out and they require you to start paying taxes on your investment. In essence, this is what Required Minimum Distributions are for tax-deferred accounts. 

Once you reach 72 (73 if you reach age 72 after Dec. 31, 2022), you are required to start pulling money out of your tax-deferred accounts. The amount is a percentage of your holdings that goes up as you get older. For example, my old man is turning 73 this year and his "life expectancy factor" is 26.5. This means he will need to take whatever amount he had in his holdings at the end of 2023 and divide it by 26.5 to get his RMD for 2024. For example, if he had $100,000 in his tax-deferred accounts he would have to pull out $3,7773.58 ($100,000/26.5). 

Roth Account Pros and Cons

Roth accounts have gotten some good press in recent years and for good reason. There are plenty of positives about them but there are also a few restrictions. 

Pros

Early Withdrawals 

Since the government already has their tax money before you contribute to your Roth account, they don't much care if you pull your contributions (not any growth). For example, your Roth IRA is worth $15,000 but you have contributed $12,000 and the $3,000 is growth. You would only be able to take out the $12,000. While this can be a nice benefit in case you encounter an emergency, it can also be tempting to use it in a non-emergency situation. Use caution.

No required distributions

Once you put your money into a Roth account, no one can force you to take it out. You can let that sweet compound interest work for you as long as you want and never, I said never, pay taxes on it. Let it ride, baby!

Cons

Income Limits

There can be too much of a good thing when it comes to income, or at least there can be when it comes to contributing to a Roth IRA. There is a cap on how much income you can bring in to contribute to a Roth IRA. For 2024, the income limit is $161,000 for single filers and $240,000 for married filing jointly. 

However, there is a loophole that allows high earners to still contribute to a Roth IRA. It is called a backdoor Roth IRA. It is completely legal and relatively easy to do. You first contribute to a non-deductible traditional IRA and then move it into a Roth IRA account via a conversion. 

No Upfront Tax Break

This seems obvious but people tend to like having money now as opposed to in the future. With Roth contributions, you forego a current year tax break you would get with a traditional account. This can be a tough pill to swallow come tax return time. Be real with yourself about how this might affect your feelings and motivation to continue to invest. 

So which account should you choose?

Why not both? You can split your contributions up however you choose so remember you can open multiple accounts and contribute to each. Just be sure to stay under the contribution limit.  

If you do want to pick one, the simplest way I have found to answer is to ask one simple question; "are you in a higher tax bracket now or will you be in a higher tax bracket when withdrawing from the account in retirement?" The paradox of this question is that you would need to know this answer in order to make the best decision but you don't know the answer because you can't foretell the future unless, of course, you are Miss Clio (shoutout to anyone who got this reference).

While you don't know for sure, you can use some basic logic to help answer the question. If you are just out of college and working your first full-time job, you are likely in a lower tax bracket now than you will be in the future so Roth may be a good option. If you are CEO of Mega Giant Inc. that you will step down from in the future and live a simpler lifestyle in retirement then traditional may be a better option. 

The other piece to consider is the tax brackets set by the government. If you look back at the last 50 years, we are currently in historically low tax brackets. Combine this with the fact our tax brackets are set to go up at the end of 2025 when the Trump Era tax cuts come to an end. For these reasons, Roth contributions are more attractive at this point BUT it is not the case for everyone. Always be sure to speak with your financial advisor and/or tax professional to understand what is best for your profile. 

The last thing I will say is that the importance of choosing the right type of IRA pales in comparison to the importance of contributing towards your retirement. Don't let the minutiae of the decision overwhelm you to the point that your decision ends up being doing nothing. Consistent contributions are the key regardless of which you choose.