Step 3: Roth vs. Traditional IRA

The one question we get the most at our Rule Your Retirement newsletter service is whether to use a traditional IRA or a Roth IRA. In a nutshell, what is the difference? We're glad you asked.

Traditional IRAs
The tax breaks for a traditional IRA are of the "this is tax-deductible" kind. That means that, depending on previously discussed factors, the money you deposit in your IRA isn't taxed. And regardless, whatever earnings you have on your contributions won't be taxed until you withdraw that money many years later.

For example, let's say you made $30,000 during the year, and you put $5,000 of it into an IRA. You'll pay income tax on only $25,000 of those earnings. Additionally, your deposit will grow free of tax through the years. When you finally withdraw the money for your retirement -- after age 59 1/2 -- then, and only then, will the money be taxed as income at your ordinary income tax rate.

If you withdraw the funds before age 59 1/2, then in most cases, you'll have to pay both income tax and a 10% penalty on whatever earnings have accrued -- although there are some exceptions where the penalty may be waived.

Remember that you can put just about anything you want in an IRA account. Under the onslaught of marketing from banks, you may have come to the conclusion that an IRA is somehow connected to a CD (certificate of deposit). That's what most banks sell, but be advised, Fool: You're not limited to what the banks offer. If your outlook is Foolish, you'd like to take control of your investing future, and you think you can develop some market-beating returns, then by all means, plunge ahead with IRA and tax savings happily in hand!

The Roth IRA
The tax breaks for a Roth IRA are different. Unlike a contribution to a traditional IRA, a Roth IRA contribution is never deductible. Taking the above example, you'd still be taxed on $30,000, even though you had put the same $5,000 into a Roth IRA. However, when you withdraw the money from a Roth IRA, none of it -- and that includes the earnings -- will be taxed, assuming that the Roth IRA has been open for at least five tax-years, and that you're older than age 59 1/2. That's right -- you get off scot free with the booty. All you have to do is to wait until you can withdraw it penalty-free. Again, that's after age 59 1/2, and as long as the cash in question has been in there for at least five years.

In other words, the Roth offers tax-exempt, rather than simply tax-deferred, savings. One word makes a big difference. While both allow you to accumulate wealth without paying taxes along the way on your profits, the traditional IRA ultimately sticks you with a tax bill for those profits (plus your initial contributions, if those were deducted when made). The Roth doesn't. As long as you follow the rules, you never pay taxes on your gains. So paying the piper now, before contributing to the Roth, may work out better for you than paying later on your investment profits.

The Roth makes particular sense for people otherwise limited to making non-deductible contributions to a regular IRA. And the Roth is fully available to single filers making as much as $112,000 in 2013 or $114,000 in 2014, and for couples making up to $178,000 in 2013 or $181,000 in 2014

It also allows you great flexibility by allowing you, in many cases, to withdraw your principal contributions tax-free at any time, without penalty. First-time homebuyers can also pull out $10,000 in profits penalty-free and tax-free, if the money has been in the Roth IRA for at least five tax years. There are also some breaks for education spending, though a Coverdell Education Savings Account or 529 plan may be better vehicles for education savings. Barring these exceptions, though, profits withdrawn before retirement age, and before the money has been in the Roth for at least five tax years, will be taxed. You'll also incur a 10% penalty when those earnings are taken before age 59 1/2.

You can plug in your own numbers to compare the two types of account by using our IRA calculators.

To convert or not to convert
Because the Roth is potentially better than the traditional IRA, it may make sense for you to convert a current traditional IRA into a Roth. To do so, you will have to pay taxes on your old IRA, but there will be no penalty for early withdrawal. Is this a smart thing to do? The answer depends on your income tax rate today versus that in retirement; how you will pay the income tax bill due on the conversion; how long the Roth IRA will remain untouched; and the size of the IRA coupled with your desires for your estate. For a discussion of some of the considerations involved in making such a decision, see this article.

In general, though, if you have to use your IRA savings to pay taxes triggered by shifting them to a Roth, you may be sacrificing too much principal up front to make the deal worthwhile, unless you have many years to make up for this dip into your savings. You should also note that funds rolled over into a Roth IRA come under greater restrictions for penalty-free and tax-free distributions, compared to normal Roth IRA contributions.

Want to make a quick conversion comparison? Use our handy IRA calculators to plug in your own numbers and see whether conversion is for you.

Once you've solved the "traditional vs. Roth" dilemma, there's just one thing left to do: Open an account.


Read/Post Comments (16) | Recommend This Article (100)

Comments from our Foolish Readers

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  • Report this Comment On April 03, 2011, at 6:29 PM, kfawell wrote:

    All other things being equal, it does not matter when the tax is deducted. The formula for compound interest is

    F1: P x f(r, n, t)

    where P is the principal, f is a function of the interest rate, n is the number of times compounding is done, and t is time. As you can see, P is all by itself. It has nothing to do with time or rate or anything else. In other words, there is a factor based on time and rate which you multiply by your principal. For example, if f evaluates to 2, your money doubled, and you would have P x 2. Another way to put that is, the amount your principal will grow can be calculated without knowing how much principal you have. That is why tables of compound interest can be calculated on their own.

    Not lets apply taxes IRA style, which come when you withdraw:

    F2: ((P x f) * (1 - TW))

    where TW is your tax rate when you withdraw. The parentheses control the order of evaluation, so this shows that you earn your interest then apply taxes. And now for Roth, which is before your deposit:

    F3: (P x (1 - TD)) * f

    where TD is the rate when you deposit. This time you apply taxes then growth.

    Look at F2 and F3. If TW is the same as TD, the formulas are the same (because it does not matter what order your multiply numbers). You would end up with the same money either way. We can write the formula this way then:

    F4: P * (1 - T) * f

    where P is principal, T is the tax rate and f is the result of compounding.

    Now the principal (to a limit) of an IRA is deductible where for Roth it is not. So IRA is better in that way.

    The interesting variable is the tax rate. It seems likely that you will pay a higher tax rate now than you will when you withdraw simply because you will have more income now than when you retire. If that were true, then IRA again is better. If your tax rate will be higher when you withdraw, Roth is better. Also, if your IRA principal is not deductible, then as pointed out, it will be taxed twice. I don't know what the tax rate will be when I retire, so I cannot reasonably use that except to point out that tax rates are pretty low historically speaking, so if they were different when I retire, they would be likely higher then.

    As pointed out, things get more complicated depending on how much is tax exempt and tax free.

    The miracle of compound interest is that the function f is exponential, and in this case that means f will get huge given enough time.

  • Report this Comment On September 02, 2011, at 2:56 PM, WineHouse wrote:

    The above comment is totally specious. It fails to take into account a WHOLE BUNCH of things -- and perhaps the most significant of these is the fact that, for "high income earners," you have to pay income tax on the current-year contributions to your traditional IRA each year that you contribute. Then the growth compounds tadx-free, but then whatever you withdraw gets taxed at "ordinary income rates" at withdrawal time on everything except that original taxed amount (which, by the time you start to withdraw, is hopefully only a tiny proportion of the total). On the other hand, there are NO taxes due on withdrawals from Roth IRA accounts, regardless of whether it's "original contribution" or growth. So since the high income earner has to pay those initial taxes anyway, it makes a lot of sense to convert those traditional IRA amounts over to Roth as soon as possible, before taxable growth accumulates, and then let the rest of the growth accumulate 100% tax-free thereafter. Yes, it's thievery from the Federal treasury coffers, but the Congress made it legal so you may as well take advantage of it while it lasts.

  • Report this Comment On January 09, 2012, at 4:10 PM, drsteve10 wrote:

    To add points for the Roth IRA--distributions do not have to be taken when you reach 701/2, allowing the account to continue to grow if you don't need that portion of your retirement funds.....and as an investment vehicle can be passed on to grandchildren and withdrawn over their projected lifetime of 70 to 80 years! and still not taxed!!

  • Report this Comment On February 09, 2012, at 11:26 AM, walkloud wrote:

    There is a flawed assumption in the comment above by kfawell - and that is that the investor in the Roth IRA will take the taxes up front out of their investment principal. Most likely, the investor will fix the investment amount, and eat the taxes out of their remaining income.

    Take a very specific example. Suppose you start with $1000, and that the tax rate is fixed at 20% in both cases, and that after some time, your portfolio grows wonderfully by a factor of 1000.

    1: Traditional IRA

    Taxes up front = 0 * $1000 = $0

    Value after growth = 1000 * $1000 = $1,000,000

    Taxes paid = 0.2 * $1,000,000 = $200,000

    Your final assets = 0.8 * $1,000,000 = $800,000

    2: Roth IRA (eating the taxes up front - leaving investment fixed)

    Taxes up front = 0.2 * $1000 = $200

    Value after growth = 1000 * $1000 = $1,000,000

    Taxes Paid = 0 * $1,000,000 = $0

    Your final assets = $1,000,000 - $200 = $999,800

    3: Roth IRA with kfawell's investment assumption

    Taxes up front = 0.2 * $1000 = $200

    Value after growth = 1000 * ($1000 - $200) = $800,000

    Taxes paid = 0 * $800,000 = $0

    Your final assets = $800,000 - $200 = $799,800

    The clear way to do the best (assuming growth and time to sit on your investment) is with a Roth IRA, where you keep your principal investment fixed and eat the taxes out of your current income/lifestyle.

  • Report this Comment On February 09, 2012, at 12:07 PM, walkloud wrote:

    my example 3 has a minor flaw - I deducted $200 twice, instead of just initially - so final assets should be $800,000. The main point remains the same.

  • Report this Comment On February 18, 2012, at 9:46 AM, vette625 wrote:

    Regarding walkloud's analysis,he starts with the assumption that the portfolio grows WONDERFULLY by a factor of 1000. Given that he agrees that this growth is wonderful, let's figure what it takes to hit that goal:assume it is over a period of 40 years, about the maximum one could hope to invest in an IRA while working (note: the shorter the period of time, the harder it is to make the goal of a 1000 factor).Realizing he chose this factor to make the math easier, this translates into a 12.2% ANNUAL return. Having invested for 50 years, I can tell you NO ONE including the pros on Wall Street EVER achieved such an annual growth.

    However, he does come to the proper conclusion that the Roth gives you more money regardless of the years assumed or the interest rate (both earned and income tax).

  • Report this Comment On January 16, 2013, at 3:18 PM, pbd2013 wrote:

    There are many valid points stated above and there are many variables.

    However, none of the illustrations is totally correct. There are some missing elements.

    To make a contribution requires income. The amount of income required to make a $1000 contribution differs depending on the type of account.

    Assuming current taxes (T) are 20%, then $1000 income is required for the traditional IRA while $1250 is required for the Roth.

    $1250 * (1-T) = $1250 * 0.8 = $1000

    You pay $250 of current income to cover taxes. That money impacts your current lifestyle and is also an investment opportunity cost. At the 1000 percent increase used above it equates to $250,000 of lost investment.

    Assuming that the traditional IRA contribution is deductible from current taxes, there is also a current income tax savings of $1000 * 0.2 = $200. This means the $1000 contribution to the traditional IRA costs you only $800 because of reduced tax burden. The additional $200 can be used many ways to improve one's lifestyle or to save. If invested back into the IRA tax-free, it could add up to $200,000 based on the 1000% return.

    The long term difference between the Traditional and Roth could add up to $450,000!

    In the end, instead of having $1,000,000 in a Roth IRA you could have $1,200,000 in a traditional. But after taxes the traditional IRA is $1,200,000 * 0.8 = $960,000. However, the Roth investment resulted in a lost opportunity of $250,000. It was a negative impact to your lifestyle over the investment period.

    If you run this analysis by starting with $1000 of available income to invest rather than a fixed investment then the results are different. Only $800 is available after taxes to invest in the Roth while $1000 can go to the traditional IRA. The after tax difference is then $160,000 more for the traditional than the Roth IRA. If the $200 tax savings is ignored (not invested) then there is no difference in the IRAs but you had $200 more to spend today.

    Everyone's income, tax rate status, and deduction circumstances are different so this doesn't

    work for everyone. It just points out other considerations when choosing options.

  • Report this Comment On January 16, 2013, at 9:12 PM, Augeydoggy wrote:

    These still look like apples and oranges to me, tho pbd2013 maybe just needs a little more clarity to prove his point.

    First of all, the initial tax difference is sometimes being treated as a Roth add-on, and sometimes as a Traditional freebie. How about if we make the contributions exactly equal, and exam a the present value cost of a stream of flows?

    Assume each IRA is to receive $1000 per year for 10 years, that the tax rate is 20%, and that the cost of money is 3%. At the end of the 10 years, the value of the IRA's will be equal. But, for the traditional IRA, the tax savings mean that only $800 is being invested each year, while the Roth requires the full $1,000. The Net Present Value of the traditional IRA cash flow is then $6,720.86, while that of the Roth is $8,530.20. So the traditional requires about 20% less cash to reach the same value.

    Second, at least in my case I expect my post-retirement tax rate to be far lower than pre-, as I won't have any work income. If our investors did well and earned 7% per annum, the value after ten years will be $14,783.60. The taxable gain is $4,783.60. 20% of that would be $956.72, far less than the investment savings. If the rate is lower, as I expect mine to be, say 15%, the taxes due will be $717.54. At the same cost of 3%, that $717.54 ten years from now has a present value of $533.92 versus the $1,809.34 savings I calculated above.

    LIke pbd2013 says, everyone's circumstances are different, but I think the scenario I outlined above is going to be pretty common.

  • Report this Comment On January 21, 2013, at 3:39 PM, Augeydoggy wrote:

    Except I forgot to tax the traditional contributions. Let's make it a little more real world, with a tax rate of 30% during contribution years, and 15% during withdrawal. Both investors earn $5000, and both withdraw the funds over 10 years. What is the present value of the total stream of funds over the 20 years using 3% inflation as cost of funds?

    Traditional (-$700 for 10 years, +$1275 for 10 years):$2,121.63

    Roth (-$1,000 for 10 years, +$1500 for 10 years): $990.71

  • Report this Comment On March 15, 2013, at 11:24 AM, KISS66 wrote:

    A simple example given :

    -Put Trad. and Roth contributions = $5000 each into Fund X.

    - Inflation diminishing factors parallel.

    -Commonly, retirement tax rate is lower historically for Joe Average say 10% vs 20% - crystal ball this one.

    -Joe takes his $1000 tax savings from Trad. IRA and invests it in the same Fund X for equal (here's the catalyst) COMPOUNDING growth for all 3 investments.

    -Doesn't Trad IRA total = Roth IRA total so far?

    -Now in retirement.

    -Trad IRA can factor in the additional COMPOUNDED

    growth of an invested $1000/yr. tax savings. (Thanks to Uncle Sam)

    (Trad IRA gain + Deduction gain) - retired rate (lower rate on lower inc.) = __?__.

    -The Roth gain stands alone albeit untaxed.

  • Report this Comment On April 27, 2013, at 5:27 PM, Komrad wrote:

    I don't have time to do all of the numbers, but I'd like to compare returns if you have $1200 and

    1. Invest $1000 in Trad IRA and $200 tax savings into same fund (but taxable)

    2. 1. Invest $1000 in Roth IRA and pay uncle same the $200 tax.

    Assuming earnings, income, and tax rates are the same. Who will have more money at the end?

  • Report this Comment On September 01, 2013, at 12:51 PM, nmtwinsfan wrote:

    The US has a progressive tax schedule. The more you make the more you are taxed percentage wise. So the question is, do you think you will be making more when you retire or less? I'm pretty sure that for the majority it would be less.If that is the case, you will be paying less as far as a percentage for taxes so a traditional IRA makes more sense. If you feel that you will be earning more in retirement than you are now while working then it would be a Roth IRA for you. It's that simple!

  • Report this Comment On December 01, 2013, at 4:32 PM, freevito wrote:

    Here's another perspective on the choice between traditional and Roth IRAs.

    The truth is that, unless you know for certain what your tax rate will be when you're ready to take distributions, the most likely scenario is this: If your income is higher than it is when you invest, your tax rate will be higher when you cash out. Conversely, if your income is lower in the future, your tax rate will be lower. Of course, who knows what the politicians will do to the tax code, but that seems like the most reasonable scenario based on history.

    The question is, what are the consequences of guessing wrong? Well, if you go with a Roth IRA and it turns out that your tax rate will be lower in the future, you missed out on whatever advantages you otherwise would have had with the traditional IRA in exchange for not having what turned out to be a lower tax burden anyway. You might have done much better if you had taken the deduction you’d have gotten with a traditional IRA and put it to more productive use.

    On the other hand, if you go with a traditional IRA and it turns out that your tax rate will be higher in the future, you'll get walloped with a bigger tax bite than if you had gone with the Roth IRA.

    Now, this is where I consider the traditional IRA to be a hedge. If my income is higher in the future, sure...I’ll have to pay more taxes. But then again, if my income is higher, I'll be in a better position to pay those taxes. On other hand, if my income is lower, I won't have the big tax bite, and I will have gotten the advantage of the deductions in the meantime.

    Folks who have greater certainty about their most likely future income (and the resultant tax bracket) probably have an easier time deciding which is better for them. But for those whose uncertainty is greater, the traditional IRA might be a more reasonable hedge, because if you guess wrong and your income is higher, at least you won't be scrambling to pay the tax man.

  • Report this Comment On February 21, 2014, at 9:29 AM, jimknob wrote:

    It's good to see these comments, and I defer any intense math formula calculations to others, but do these general thoughts should be considered?

    1. Tax Bracket -- If it is higher in the future, have some money in a Roth. If lower in the future, have more in the Traditional IRA.

    2. Current bracket: Even if you're in the higher bracket now, it still means that some of your income is in a lower tax bracket. So, it's very possible that some of your IRA withdrawals will be in a lower tax bracket.

    3. Personal Deductions: Currently a couple aged 65+ on Social Security can have about $20,000 of income above and beyond Social Security, and still be in a zero federal tax bracket due to the $13,000+ standard deduction and $6,900 personal exemptions.

    4. Future Possible Causes for higher income taxes? Extra IRA withdrawals; IRA RMD @ age 790 1/2; Having your Social Security taxed; and having to file as a single person the year after your spouse dies.

    5. Possible ratio of IRA vs Roth values: Maybe 4:1 if you are confident on having some future retirement money in a zero or lower federal tax bracket. Maybe 2:1 if you might be in the same bracket. Maybe 1:1 if you estimate that some of your income will be in a higher tax bracket.

    5. Summary: There is no set formula for everyone, but it can make a difference to analyze your situation and consider diversifying your income tax strategies much as you might diversify your investment portfolio.

    PS: Interesting point on realizing that if you are in a higher tax bracket when you withdraw future IRA money, at least that means you have more money; however, I'm betting most people do not like paying more income taxes as they get over age 70.

    Just some thoughts-- nothing scientific.

  • Report this Comment On February 22, 2014, at 9:02 AM, thepalmersinking wrote:

    To simplify. Take the Roth. Life tax free off dividends and covered call premiums.

  • Report this Comment On October 10, 2014, at 9:06 PM, CalvinJamesK wrote:

    Your websites retirement help has been extremely helpful to me! I'm still years away from retiring but I have heard countless times how important it is to start preparing young. I feel like I could be do my taxes more efficiently though. I'm going to try using a tax preparing service this year and see how it goes.

    http://www.hill-cpa.com/Tax-and-Advisory-Services.5.htm

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