Wednesday, December 16, 2009

IRAs: Traditional vs. Roth

There are lots of detailed regulations for Individual Retirement Arrangements (IRAs), so to really dig into it, you should read the relevant sections of IRS Publication 590 (html version -- see the PDF Version if you prefer the format used for the printed publication) which covers IRAs in depth.  On the second page of the html version or page 5 of the PDF version, there's a table that summarizes differences between Traditional and Roth IRAs.  I'll summarize some of the differences and similarities here.

With either IRA, your annual contributions are limited.  For 2009, the maximum contribution is $5000 ($6000 if you are over 50).

With a traditional IRA, contributions are deductible unless you make too much money (see Pub 590 for the details).  This means you pay less federal and state income tax, and may be able to put more money to work in your investment portfolio.  Another way to think about it is that the government is giving you an interest free loan that you can invest for many, many years.  For example, if you're in the 25% federal and 9.55% state tax brackets, and you contribute the maximum $5000, you'll save $1,713 in taxes.  So, you're only reducing your take home pay by $3,287, but you get to invest $5,000.  The extra $1,713 grows at whatever your compound annual return turns out to be until you start taking withdrawals in retirement. 

You don't pay any taxes on earnings from a traditional IRA until you (or your heirs) start taking distributions.  So, interest, dividends or capital gains distributions on which you normally would pay taxes (in a taxable account) can be reinvested, and continue to earn more interest, dividends, or captial gains.  This is known as tax-deferred compound growth, since you're earning interest on the interest that otherwise would've been paid in taxes.

However, you (or your heirs) eventually have to pay taxes on the tax-deferred contributions you make to a traditional IRA (that's why they're called tax-deferred contributions, and not tax-free contributions).  When you start taking distributions from your IRA (which you must do by age 70 1/2), you'll pay taxes at whatever your ordinary income tax rate is at the time.  You don't receive any special tax treatment for capital gains (e.g., the increase in value in your stock mutual fund), as you would in a taxable account (at least under current tax law).

With a Roth IRA, contributions are not tax deductible.  So, assuming the same marginal tax rates as above, your $5,000 contribution to a Roth IRA comes out of $7,639 of earnings, and your take home pay is reduced by the full $5,000.  So, the bad news is that contributing to a Roth IRA doesn't reduce your current tax bill, but the good news is that the earnings are tax free; i.e., you (or your heirs), will never pay any taxes on any distributions taken from your Roth IRA.

So, assuming you meet the criteria to make tax deductible contributions to a traditional IRA or taxable contributions to a Roth IRA, which makes more sense?  Unfortunately, there's no simple answer, since it depends on a number of variables, some of which it's impossible to know the value of.  One of the big unknowns is your tax rate when you take distributions in retirement, which is very difficult if not impossible to predict.  Many people think tax rates must be higher in the future, to help pay for the burgeoning budget deficits.  On the other hand, your taxable income may be significantly lower in retirement, which would tend to lower your tax rate.

If you can't afford to reduce your take home pay more than $3,500 - $4,000 (the exact number depends on your federal and state marginal tax rates), and if you assume that your marginal tax rates upon withdrawal will be the same as your marginal tax rates upon contribution, then it can be shown that it makes no difference whether you use a traditional or Roth IRA.  This is because while you can afford to contribute more to a traditional IRA (because of the tax deduction), the taxes you pay upon withdrawal exactly offset the additional contribution and its compound growth.

However, if you can afford to reduce your take home pay by more than about $4,000 (again, the exact number depends on your tax rates), then additional tax free compound growth of the Roth IRA begins to give you a slightly higher net withdrawal

If you invest the traditional IRA tax savings in a taxable account, the benefit of the Roth IRA is somewhat reduced, but the Roth still comes out ahead!  You get the maximum benefit from a Roth over a traditional IRA if you are able to afford to reduce your take home pay by exactly the amount of the maximum allowed contribution ($5,000 if under age 50).  However, the benefit is greatly reduced by investing your traditional IRA tax savings in a taxable account.

All of the above conclusions are affected by the difference between your marginal tax rates upon contribution and upon withdrawal.  Significantly lower tax rates in retirement result in the traditional IRA being the better deal, while significantly higher tax rates in retirement result in the Roth IRA being the better deal.

Given that it's difficult, if not impossible, to know if you'll be better off in the long run with a traditional or Roth IRA , you may want to consider a strategy that some people call tax diversification: split your contributions evenly between traditional and Roth IRAs.  This gives you some immediate benefit of the tax deduction from your traditional IRA contribution, as well as the long term benefit of taking tax free distributions from your Roth IRA in the future. 

However, if you're eligible for a 401(k) or 403(b) plan at work, and you can afford to save at least $10,000 per year, then you might consider contributing $5,000 to a Roth IRA (only), and the other $5,000 (more if possible) to your 401(k), which enjoys the same tax deferral benefits as a traditional IRA.  This gives you the same tax diversification, but allows you to take more advantage of the long term tax free earnings of the Roth IRA.

Once you start making over a certain amount of money (technically, once your modified adjusted gross income exceeds the limit specified by the IRS), your contributions to a traditional IRA won't be deductible, but you can still contribute the maximum annually, and defer paying taxes on the earnings until you start taking distributions; i.e., you still get the benefit of tax-deferred compounding.

There's also an upper limit on how much money you can make, and contribute to a Roth IRA.  If you make too much to get the deduction for the traditional IRA contributions, but not enough to exceed the limit for Roth contributions, then the decision is easy: contribute to a Roth IRA.  If you're not going to get the tax deduction with a traditional IRA, then it's a no brainer to go for the tax free growth of the Roth. 

If you make too much to contribute to a Roth IRA, then I'd still recommend contributing to a traditional IRA for the tax-deferred growth benefit, assuming you're contributing the maximum to your 401(k) if you're eligible to do so.  This is the only case where non-deductible traditional IRA contributions make sense: i.e., you've maxed out your 401(k) or 403b contributions, and you make to much money to be eligible to make Roth IRA contributions.


  1. Is there generally a cap on the amount of money you are allowed to put in your 401k? If so, does that depend on the company you work for?

    Also, what do you mean by, "if you make over a certain amount of money, your contributions to a traditional IRA won't be deductible." Does this mean that after that certain amount of money, you may be getting the same benefits of a roth IRA from a traditional IRA? I'm confused...

  2. Since this post was focused on IRAs, I didn't get much into 401(k), but yes, there's a cap on 401(k) contributions, but it's much higher than that on IRA contributions. Since it deserves an article on it's own, I'll just say here that the cap is high enough that it's unlikely you'll be able to save enough to max out on 401(k) and IRA contributions if you're just getting started working.

    Regarding the second question, I was trying to get at that when I talked about it being a no-brainer if you made too much for your traditional IRA contributions to be deductible, but not enough to disqualify you for Roth IRA contributions. In this income range, the Roth benefits are not the same, but actually superior to a traditional IRA, since you would be taxed on traditional IRA distributions (when you retire and start taking money out), but Roth IRA distributions will be tax free.

    Hopefully this answers your questions, but if not, just keep asking until it's clear ;-)

  3. I would love a follow-up article on 401k plans, including what questions to ask a potential employer.
    Thank you!

  4. So how much money do you need to be making (amount) when you won't be eligible to contribute to a Roth IRA?

  5. On the traditional IRA -- the money that is tax-deferred, and you won't be taxed until you take it out later -- Will you be taxed on the amount you've accumulated? Or just the amount you've put in.

    So basically, this all depends on what your current situation is -- if you can afford to get taxed right away and put into a ROTH IRA -- go for it, but if it would make more sense for you financially, put it in traditional so you can save money on your taxes now?

    Just clarifying...

  6. For us newbies, how do we make the connection (after contributing to a traditional or roth IRA) from your contribution to reporting it in your taxes?

  7. In answer to Kristen's question about how much you can make before becoming ineligible to contribute to a Roth IRA, the best thing to do is look up the answer in IRS publication 590. In my original post, click on the link to IRS Publication 590 (html version), then scroll down through the table of contents to section 2 (Roth IRAs), then click on the 7th bullet below that (Can You Contribute to a Roth IRA?).

    I highly recommend that you take a few minutes to do this. It's likely to raise other questions, but answering them gets into a course on income taxes.

    For now, I'll only add that unless you make over $100,000 (and are single), you don't have to worry about it.

  8. Kristen asked about exactly what gets taxed when you take distributions from a traditional IRA (e.g., when you start taking money out of your IRA in retirement). Basically, you get taxed on everything you haven't already paid taxes on. I'll use examples to illustrate.

    Jack is single, age 25, and makes $50,000 per year. He makes a tax deductible contribution of $5,000 to a traditional IRA, and for whatever reason, never makes any more contributions. When Jack turns 65, his $5,000 contribution has grown to $80,000 (seems like a lot, but if he manages to make 7.2% annual compound return, the rule of 72 tells us that his money will double every 10 years, so in 40 years it will double 4 times: i.e., 10K,20K, 40K, 80K); Jack withdraws the entire $80,000 at age 65. Since he didn't pay any taxes on the original contribution, he will pay federal and state income taxes on the entire $80,000.

    Jill is single and makes $150,000. She makes too much to contribute to a Roth IRA, plans to maximize her 401(k) contributions, but can still afford to contribute $5000 to a traditiona IRA, and does so. From here on, we'll assume the same scenario as Jack (no more IRA contributions, 7.2% return, withdraws $80,000 at age 65). Since Jill already paid federal and state income taxes on the original $5,000, she owes taxes on $75,000 of the $80,000 withdrawal.

    These examples also point out the huge potential benefit of a Roth IRA (which unfortunately, Jill wasn't eligible to take advantage of). Let's say that Jack could've afforded to pay the taxes on his earnings, and still to contribute $5,000 to a Roth IRA (remember, no tax deduction for Roth IRA contributions). Assuming the same facts as the above scenarios, Jack could withdraw all $80,000 from his Roth IRA and pay absolutely no taxes!!!

    So, assuming you are willing to forego the immediate benefit of paying less taxes today, and that you can get a decent return on your investment over the next 40 years (and that Congress doesn't do something to take away the Roth benefits, and that you live 40 more years, etc., etc., etc.), the Roth IRA is the big winner in the long run.

  9. Kristen asked: "For us newbies, how do we make the connection (after contributing to a traditional or roth IRA) from your contribution to reporting it in your taxes?"

    There's a line on your tax return (form 1040, 1040A, etc.) where you enter your IRA deduction (on 2008 form 1040, it was line 32). If someone does your taxes for you, they will help you with this (if they don't ask you about IRA contributions, find someone else to do your taxes!). If you use a tax program like TurboTax, it will help you figure out if your contribution is deductible. Otherwise, you need to follow the instructions for form 1040 to determine if your contribution is deductible.

    Of course, you should have this figured out before you do your taxes, so that's when you should be figuring it out by reading the IRS publications or a good tax book or guide, or getting some help from your tax advisor.

  10. There are many IRA-related topics I didn't cover in the original post, which is why I emphasized the importance of referring to the IRS tax publication (590). For example, the limitation on deductibility of traditional IRA contributions is not only based on income, but also on whether or not you (or your spouse) are covered by some kind of retirement plan at work. A 401(k) counts as a retirement plan. The post wasn't meant to provide comprehensive coverage of IRAs, but just to give you a basic understanding of the differences between traditional and Roth IRAs, and hopefully help you decide which makes more sense for you. To go much further than that, you must either do quite a bit of studying on your own, or consult a tax advisor.