Don't get me wrong. There are plenty of advantages to socking away money in a Roth IRA. My fellow Fool Michael Douglass recently made a great argument for why he's a fan of those plans. Roth IRAs are a good fit for Michael, but our situations are different. So, while he (and many others) prefer Roth IRAs for their savings, I prefer using a traditional IRA. Here's why.
No. 1: Reality sets in
It's tempting to extrapolate our current income into the future and assume the best, but the reality is that most of us will pay a lower tax rate in retirement than we do now.
In my case, even if I retire with a $1 million nest egg, I'll only be withdrawing about $40,000 per year in retirement, assuming I stick to the 4% rule. If I don't need the money sooner, then I'll only be forced to take about $36,000 out of my traditional IRA when required minimum distributions kick in beginning at age 70.
Admittedly, I have no idea what tax rates will be in the future, but I'm betting that the income tax rates on those relatively small withdrawal amounts will be lower than the tax rate I'm paying now.
After the passage of tax reform this month, I expect to be in the 22% tax bracket next year. For comparison, if I were retiring next year and withdrawing $40,000, my tax rate would be 12%. For this reason, I'd rather have the tax break associated with making pre-tax contributions to a tax-deductible IRA now than the tax break associated with making post-tax contributions to a Roth IRA later.
No. 2: Bird in the hand
Because traditional IRAs are funded with pre-tax dollars, I get tax savings up front that I can invest or use to avoid high-interest credit card debt, and thanks to compound interest, those are substantial benefits over time.
In 2018, the contribution limit for a regular traditional IRA is $5,500, or $6,500, for those age 50 and up. So, if I contribute $5,500 to a traditional IRA in 2018, it would produce a $1,210 tax savings for me, based on my 22% marginal tax rate. If I did that every year for 20 years and invested my savings in a low-cost S&P 500 ETF that earns a hypothetical 7% annually, I'll have increased my nest egg by about $50,000.
In my situation, though, my savings will be bigger than that because I've established a SEP IRA. SEP IRAs are a type of traditional IRA that small businesses (and independent financial writers like me) can use to save more money and claim a bigger tax deduction. In 2018, I can contribute the lesser of 25% of income or $55,000 per year to my SEP IRA.
Overall, my preference for tax-deferred retirement savings stems from my belief in the time value of money. I'm simply convinced that money today is more valuable than money in the future.
No. 3: No plans to tap it, but I could...
I don't plan on touching my traditional IRA until retirement, but let's face it, life happens.
Fortunately, traditional IRAs aren't buried underground, locked away in a vault without a key. Yes, I'll pay income taxes on money I withdraw, plus a 10% penalty if I'm younger than 59 1/2 years old. But in a pinch, I can get my hands on this money.
In fact, the IRS has rules that make withdrawing money from a traditional IRA less painful than it might be otherwise.
For example, first-time homebuyers like my son can tap his traditional IRA for up to $10,000 without paying the 10% penalty. Importantly, if his home purchase falls through (or he wins the Lotto), he can replace any money he took out within 120 days and get a do-over on the withdrawal. Heck, if he's running a bit shy on his downpayment, the IRS even lets me tap my traditional IRA penalty-free to help him buy his first home.
The IRS also allows penalty-free withdrawals from traditional IRAs for tuition or when medical expenses eclipse 10% of income. It allows penalty-free withdrawals to pay health insurance premiums if I end up unemployed, too.
Furthermore, even if I withdraw money from my traditional IRA for some other reason, I can still reverse my withdrawal within 60 days and avoid the taxes and penalties. Again, I'll pay income taxes on this money, so withdrawing it would be a last resort, but it's an option.
The fine print
I may prefer traditional IRAs, but that doesn't mean that a Roth IRA isn't the best option for you. There's a lot to like about Roth IRAs, especially in terms of legacy planning. For instance, a stretch IRA can help make sure your loved ones are financially secure throughout their life after you're gone. Roth IRAs, however, do have income limits, so even if you prefer the idea of tax-free withdrawals in retirement, you might not be able to contribute to one. Currently, if you're married with adjusted gross income greater than $199,000, you're ineligible to contribute to a Roth IRA.
Overall, when it comes to the traditional IRA versus Roth IRA argument, there's no one-size-fits-all winner. You'll need to do your homework and then make the better-informed decision you can.