Setting aside money every year in an IRA can make a big difference in retirement, particularly if you start contributing when you're young. But deciding which type of IRA to invest in can be difficult. Traditional IRAs allow investors to take an income tax deduction on their contribution during the current year, but during retirement, withdrawals are taxed as income. Roth IRAs require investors to pay income taxes on their contribution up front, but withdrawals in retirement are tax-free.
To help investors decide which of these retirement account options may be best, we asked three Motley Fool contributors to share their opinions.
My answer is along the lines of "it depends." For some people, Roth IRAs make more sense, while traditional IRAs can be the best way to go for others.
If you are ineligible for a traditional IRA tax deduction because you or your spouse participates in an employer-provided retirement savings plan and your income exceeds a certain threshold, then the Roth IRA is the obvious choice. Likewise, if you are ineligible for a Roth IRA because your income exceeds a certain threshold but qualify for a traditional IRA tax deduction, then the traditional IRA is a no-brainer.
If you are eligible for both, it comes down to when you want your tax break. If you contribute to a traditional IRA now, and income tax rates double in the future, you might kick yourself for choosing the upfront tax break. On the other hand, if you contribute to a Roth IRA and then retire in a lower tax bracket than you were in when you made those contributions, you'll have missed out on a tax deduction.
One benefit of a Roth IRA is that you know what tax rate you will pay on your contributions, so there won't be any surprises later, no matter where tax rates go.
There are three reasons I believe Roth IRAs are better than traditional IRAs:
- Since you have paid taxes on the money you are contributing, you can withdraw your principal (but not any gains on that principal) at any time without incurring early withdrawal penalties.
- If you are comfortably able to deal with the taxes, pay now so your future self doesn't have to. Who knows what the future might hold; down the road, you might not be in such a financially secure position, so I think it's worthwhile to have the option to access your funds in retirement without owing any taxes on them.
- Taxes in the future will likely be higher. One reason for this is demographics. As Americans live longer and baby boomers retire, the percentage of American's over 65 is expected to rise from 13% to 20% over the next 15 years. Therefore spending on Medicare, Medicaid, and Social Security will need to rise to support American retirees. At the same time, Americans are having fewer kids on average, which means fewer taxpaying workers to support the older generations.
Furthermore, the national debt is at 74% of GDP, its highest level as a percentage of GDP since WW2. As it grows, interest expenses on the debt eat up a growing portion of Federal tax dollars, meaning that money can't go toward government programs. In order to maintain the programs we have now and keep the national debt from going above 100% of GDP, taxes will have to be raised, or else the nation's debt will rise to dangerous levels.
Assuming taxes rise, those who earn the most will probably bear the brunt of the tax hikes. Using 2011 data from the IRS, the top 5% of Americans by wealth earned 34% of all income, and the next 20% earned 33% of all income. Combined, that means the top 25% of Americans earn 68% of all income. To be in the top 25%, you needed to make just over $70,500. If taxes have to rise, tax rates will rise for those who are earning most of the nation's income; there just isn't much income tax to be had from the other 75%.
Although Roth IRAs are only open to people who are below certain income thresholds, there are ways to access a Roth IRA no matter what your income is -- for example, through a traditional IRA conversion, a rollover of a Roth 401(k), or a complicated strategy involving Roth 401(k)s.
I think the one thing all three of us can agree on is that tax-advantaged retirement accounts are awesome. They allow you to save significantly more money for retirement than taxable accounts, and investors are right to max out their investments in these vehicles every year. Although arguments can be made for Roth IRAs (you've just read some great ones), I'm a bigger fan of the good old-fashioned traditional IRA.
Most Americans have saved little for retirement, and even those who have saved diligently aren't likely to generate enough income from those investments to eclipse their top income-earning years. That means a lot of retiree income will come not from investments, but from Social Security, which is generally taxed at a low rate or not at all. As a result, the effective tax rate of many Americans has a good chance of being lower, not higher, during retirement. Therefore the upfront tax savings offered by traditional IRAs (especially if they knock an investor into a lower tax bracket) might make more sense, particularly given that there's no guarantee we'll live long enough to enjoy the full benefits of the Roth IRA's tax-free withdrawals anyway.
Additionally, while a Roth can't be converted to a traditional IRA, a traditional IRA can be converted to a Roth IRA if your expectations of future tax rates change. Lastly, one advantage of the Roth might actually be a disadvantage. Roth IRAs allow tax-free withdrawals, but investors are generally better off without the temptation to tap their retirement accounts early. The fact that traditional IRAs penalize early withdrawals actually works in your favor: Withdrawing funds early can severely stunt your retirement account's growth through compound interest. Early withdrawal penalties are a nice reminder that these accounts exist to ensure your financial security when you leave the workforce -- not to pay for expenses along the road to retirement.