To Roth or Not to Roth?

At the beginning of every year, I engage in financial planning for the new year. You may do so as well. One of the things you may be considering is whether to invest in a retirement account, and if so, how much and what type of account.

I never considered the long-term tax implications of investing in an individual retirement account (IRA) when I was younger. My thinking was simply, “If I can shelter some income from taxes, I am going to do so.”

It was conventional wisdom that when you retire, you would probably be in a lower tax bracket. Thus, IRA contributions could grow tax-free for many years before I finally began to make withdrawals, paying lower taxes on them in my retirement years.

But then another type of retirement account came along. The Taxpayer Relief Act of 1997 created Roth individual retirement accounts (Roth IRAs), and that gave investors another factor to consider.

Allow me to explain the major differences between the two types of account — which also exist in 401(k) form.

Taxation of Contributions and Withdrawals

Contributions to a traditional IRA are typically tax-deductible in the year you make them. This means you can reduce your taxable income by the amount you contribute to the IRA. However, you will pay taxes on the contributions and their earnings when you withdraw money during retirement.

Contributions to a Roth IRA are made with after-tax dollars, meaning you don’t get a tax deduction for your contributions. However, qualified withdrawals, including earnings, are tax-free in retirement.

Withdrawals from a traditional IRA are taxed as ordinary income, and there are required minimum distributions (RMDs) that you must start taking after age 72.

Contributions to a Roth IRA can be withdrawn at any time tax-free since they were made with after-tax dollars. You can withdraw earnings tax-free if you meet certain conditions, such as being at least 59½ years old and having the account for at least five years.

Income Limits

There are no income limits for contributing to a traditional IRA. However, the tax deductibility of contributions may be limited if you or your spouse are covered by a workplace retirement plan and your income exceeds certain levels.

Roth IRAs have income limits that determine whether you can contribute. If your income exceeds the limit, you may be restricted or unable to contribute directly to a Roth IRA.

Maximizing Future Account Value

The biggest factor impacting your future account value hinges around taxes. The conventional advice is that if you believe your tax rate in the future will be lower, then you should invest in the conventional IRA. That’s because you will shelter money at a higher tax rate than you will have to pay when you withdraw it.

Another consideration there may be state income taxes. If you currently work in a state with income taxes, but plan to return in a state with no state income taxes, then it may make more sense to shelter the money from state income taxes now, since you won’t have that obligation when you withdraw.

But I will give you one additional consideration. If you have a particular objective, such as reaching an account value of $1 million, you can hit that target much faster with the conventional IRA. Here’s why.

Let’s say you wish to invest $100 a week. With the Roth IRA, since that’s after tax money, you will need to earn more than $100 to invest that much. Let’s say it’s $120 for example. Then taxes are withheld, and you are left with $100.

Contrast that with the conventional IRA. In this case, if you earn $120, you can put that full amount into the account. The $20 in taxes that you would have paid goes in and then compounds for the entire time you have the account. This will get you to your goal quicker.

However, here’s the caveat. Since you eventually must pay the taxes, the after-tax value of a $1 million conventional IRA isn’t really $1 million. It depends on your withdrawal rate and other income, but maybe it’s $750,000. If you had gone the Roth route, you might still be at $750,000 when you reach $1 million in your conventional IRA. However, you can then withdraw that money with no tax obligations.

Additional Considerations

One final consideration is that you can withdraw your initial Roth contributions tax free. Thus, there may not be enough incentive to leave that money in there and let it keep growing. Note that this only applies to the contribution, and not the earnings.

But if you think the temptation to take out some of that money and spend it is too great, best to stick with the conventional IRA, which is going to penalize you for taking any of your money out (and thus provide an incentive to leave it in there).

Of course, there’s no reason it has to be entirely one or the other. You can have both types of account, and perhaps some years it makes more sense to contribute to one, but not the other.

Editor’s Note: For market-thumping gains with mitigated risk, I suggest you consider the advice of our colleague Jim Pearce, chief investment strategist of Personal Finance.

Personal Finance, founded in 1974, is our flagship publication and it has helped investors build wealth for nearly 50 years.

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