In this blog post today I want to compare a traditional IRA to a Roth IRA to help you decide what will help you optimize your retirement savings.
Let’s start with a brief overview of each::
A traditional IRA is a retirement account that allows you to contribute pre-tax dollars, up to a certain limit, each year. This means that your contributions reduce your taxable income for the year, and you don’t pay any taxes on the money until you withdraw it in retirement. The annual contribution limit for 2024 is $7,000, or $8,000 if you are 50 or older.
Not only do you receive a tax benefit on your contribution today, but all the growth in your IRA occurs tax-deferred as well. Thus, you only pay taxes on your IRA when you tax withdrawals in the future.
A Roth IRA is a retirement account that allows you to contribute post-tax dollars, up to a certain limit, each year. This means that your contributions do not reduce your taxable income for the year, and you pay taxes on the money upfront. The annual contribution limit for 2024 is the same as for traditional IRAs: $7,000, or $8,000 if you are 50 or older. However, your ability to contribute to a Roth IRA is phased out at higher incomes. For 2024, the phase-out range is $146,000 to $161,000 for single filers, and $230,000 to $240,000 for married couples filing jointly.
The main benefit of a Roth IRA is that it offers tax-free growth and withdrawals in retirement. This means that you will not owe any taxes on your contributions or your earnings, regardless of your tax bracket in retirement. This can be especially beneficial if you expect to be in a higher tax bracket in retirement than you are now, or if you want to have more flexibility and control over your income in retirement. Unlike traditional IRAs, Roth IRAs do not have RMDs, so you can leave your money in the account as long as you want, or pass it on to your heirs tax-free.
The main drawback of a Roth IRA is that it does not lower your tax bill in the present, and you have to pay taxes on the money before you invest it. This means that you will have less money to contribute to your account, and you will miss out on the tax deduction that traditional IRAs offer. Additionally, you may not be eligible to contribute to a Roth IRA if your income is too high (although a backdoor Roth may still be available).
Roth or IRA, which should you choose?
It depends! The purely mathematical answer to the question of which is better hinges on your tax rate. If your tax rate is higher today than it will be in retirement when you take your withdrawals, then you are better off reducing your income today and contributing to a traditional IRA. Conversely, if your tax rate will be higher in retirement then you are better off contributing to a Roth IRA.
Let’s look at a few simple examples. We’ll assume the accounts grow at 8% for 30 years.
Tax Rates are the same today as in retirement:
So if tax rates are the same today as they are in retirement, there should be no difference in your final after-tax value between an IRA and a Roth IRA. This holds true regardless of the growth rate or the length of time in which the account is allowed to grow.
Tax rates are higher today:
If your tax rate is higher today, contributing to a traditional IRA will result in the greatest final after-tax value.
Tax rates are higher in retirement:
If your tax rate is lower today than it will be at retirement, contributing to a Roth IRA will result in the greatest final after-tax value.
Dealing with Uncertainty in the Tax Law and Your Situation
The examples above assume we know your future tax rate. In practice, future tax rates are unknown as politicians make occasional changes. If you’re planning decades into the future tax rates will likely change.
The following chart shows that by historical standards, tax rates are fairly low today (at least at the highest marginal level):
Flexibility – Roth IRAs provide additional flexibility for those who may need to tap their retirement accounts before retirement. You can withdraw your contributions from a Roth IRA at any time without paying any taxes or penalties. It’s only the earnings and growth that would be subject to early withdrawal penalties if you tap them before 59 ½.
A bird in the hand is worth two in the bush – I think there is some value in taking advantage of the immediate tax reduction you receive with a traditional IRA today, especially for high earners. Tax policy is always subject to change and there’s a lot of political rhetoric aimed at higher taxation for those with higher income or assets. While it may seem unlikely, tax benefits from IRAs or Roth IRAs may be curtailed in the future. There were early drafts of legislation in past years that included measures like required minimum distributions from Roth IRAs for people with retirement assets over a certain threshold. While it didn’t ultimately make it into law, higher earners should take this into account in their planning for the future. The potential limitation of future benefits is one reason why I sometimes prefer taking advantage of current reductions in taxable income.
Tax Diversification – Most people have the majority of their retirement savings in tax-deferred accounts like traditional IRAs or 401Ks. Diversifying your savings across tax-deferred, tax-free, and taxable accounts can help reduce your tax burden and increase your after-tax income in retirement. Thus if you’re already heavily weighted towards tax-deferred accounts you might want to favor making contributions to a Roth IRA.
The optimal choice between a traditional IRA and a Roth IRA ultimately depends on your unique circumstances and future tax law. As the examples show, Roth IRAs are best for those who will have higher tax rates at retirement than today. Traditional IRAs are best for those who have higher tax rates today than at retirement. But be sure to consider whether you may need to tap your money before retirement, how tax law changes may impact you, and how your situation is likely to change in the future. If you need help deciding which account is right for you, or if you have any questions about IRAs or other retirement planning topics, please contact us at Sophos Wealth Management.
Scott Caufield, CFA, CPA