So I hope you’ve done your taxes for the year. I used a certain online program to do my taxes, and one of the questions asked was “Did you contribute to an IRA [Individual Retirement Arrangement] this year?” If you answer yes, you have to indicate whether it’s a Traditional IRA or a Roth IRA. If you contributed to a Traditional IRA, then (chances are) you can deduct the amount you contributed from your taxes. If you contributed to a Roth IRA, you can’t.
I contributed to a Roth IRA, and I think in most cases, it’s in your best interest to do so as well. But not for the reasons that many may think.
William Roth, meet James Traditional
A quick primer on the Roth vs. Traditional thing. You have to put your retirement money in something (the compound interest of putting your money under the mattress is quite low, historically) and if you’re doing a self-directed arrangement (i.e. not through your job) then you basically have these two choices.
- In a Traditional IRA, you can contribute money to the account without paying taxes on it. You pay taxes on the money when you withdraw it.
- In a Roth IRA, you can contribute money to the account, but it has to be post-tax (you have to have paid taxes on it already).
Proponents of the Roth IRA say that your money grows tax free. And this is technically true, though kind of disingenuous, as it’s not really the whole story.
Where I undercut my own argument
Where many Roth proponents get this calculation wrong is that they don’t start the comparison from the same place; they compare an investment pre-tax with an investment post-tax using the same amount of money. But investing post-tax means that tax has already been taken out, so you have less to start out! You have to include the part where tax gets taken out at the beginning, otherwise you imply that the investment has no taxes associated with it, and that’s just not true.
Let’s see what I mean. Assume that the tax rate is at 25% and that this remains constant. Let’s also assume that you can make 8% on your money over time (a not unreasonable assumption). For simplicity, let’s say you have $10,000 to invest, and that this happens once, and stays put for 30 years, and then is pulled out in a single lump.
In the Traditional IRA sense, you put in $10,000. Since this is pre-tax, your $10,000 investment stays as $10,000. After 30 years, your $10,000 investment will have grown to about $100,626.57 (not bad). When you pull out the money, you pay 25%, which nets you a clean $75,469.93.
In the Roth IRA, you put in $10,000, but since you are paying taxes on this, your $10,000 investment gets cut down to $7,500. After 30 years, the $7,500 investment becomes…$75,469.93.
(I used this site for these calculations.)
See what happened there? In a Roth, you never actually invest the whole amount! So the investment grows tax free, but you have already lost a big chunk at the onset. It evens out in the end. But if you calculate an investment without factoring in that initial tax chunk, of course the Roth will come out ahead. But that’s not comparing the same things. Don’t be fooled.
Where I undercut my own argument some more
One more reason why the Traditional and Roth IRAs are a push to me is because of the tax bracket arbitrage. If your tax rate is higher now than later, it makes sense to use a Traditional IRA (because you are subject to the lower rate). But if you tax rate is lower now than later, it makes sense to use a Roth IRA (because you are subject to the higher rate).
Which one should you choose? Well, not to abdicate this decision, but you let me know what tax rates are going to be in 30 years. What, you don’t know? Hey cool, neither do I.
Where I salvage my argument
But remember way up at the top where I said that I am a big fan of the Roth, and wholeheartedly recommend it to you. Here is why.
- You know exactly what you have. In a Traditional IRA, you never know exactly what you’re going to have because of the tax situation. But with a Roth, you have what you have. If it says $500,000, then that’s exactly the amount you can take out. There is a psychological component to this that appeals to me, but it also helps making planning a bit easier.
- You can decide when you wish to withdraw your money. Traditional IRAs have a mandatory distribution period that starts around age 70. With a Roth, you not only can withdraw any of your original contributions at any time (although I wouldn’t recommend this), but you don’t have to start doing so unless you want or need to. It gives more control to you.
- You can contribute more. While the maximum amounts for both types of IRAs are technically the same, the Roth actually ends up being more money. To contribute the same amount to the Roth, you’d need to have that much plus whatever is taken out in taxes. Now this may be a minor point if you’re not at the point where you’re maxing out your IRA, but you’ll eventually get to this point if you keep up with the secret life of your money.
- You probably already have a pre-tax investment. Many people have a 401(k) as part of their job, which is also a pre-tax investment account, so the Roth gives you an alternative.
Like all financial situations, the details can vary depending on your situation, so some of these benefits may not be applicable to you. Ultimately, though, whether you choose a Traditional IRA or a Roth IRA (or even both) is up to you. (Vanguard and other services like them make this crazy easy.) But no matter what method you use to invest, the most important decision is the decision to invest at all. And the mattress doesn’t count.
But enough about me. Do you use the Roth? Non U.S. folks, do you have an equivalent to the Roth IRA?