August 10, 2008

Traditional IRA or Roth IRA? Or why not both?

A lot has been written on comparisons between traditional IRA accounts and Roth IRA accounts. Its a fairly common question to decide which is better for a given person. Suze Orman is very gung ho on the Roth IRA and she seems to recommend them a lot.

First of all there are a couple situations where I think the choices are pretty clear:

1. Take advantage of any 401k employer match first
If you have a 401k employer match then go with that first. An employer match to a 401k is free money and you can't go wrong there. So if this is an option for you then the 1st priority is to contribute to the 401k up to the match level.

2. If you have a low tax rate go with Roth IRA
If your tax level is currently very low then a Roth IRA is a good choice. Lets say for example that right now you are single and making $25,000 a year. Your tax bill in in the ballpark of $2,000 or about 12% range. That is a very low tax rate and its very likely in the future you'll be looking at a higher rate. So it would make more sense now to contribute to a Roth IRA with after tax dollars and then not pay taxes in the future.

But lets if you don't have an employer matching 410k plan and you aren't in a very low tax rate presently then the choice between a traditional IRA and Roth IRA gets less clear. Lets look at the pros and cons of each.

Roth IRAs
Your future tax liability is zero.
If taxes go up in the future then it will not impact you.
You can withdraw your contribution money from a Roth for anything.
You get no immediate tax benefit from a Roth
If taxes go up in the future then you'll be paying more then.

Traditional IRAs
Lets you avoid taxes now
Better if you have a lower tax rate in the future.
Money isn't accessible until age 59 1/2
If taxes go up you'll pay more in the future

If you look at the differences the big unknown that matters here is whether or not tax rates go up or down in the future. The common feeling I've seen lately from people like Suze Orman is that its likely that tax rates will be higher in the future. Suze and others say this is more likely since we've got looming debts and our nation is facing higher bills for social security. So they expect taxes to go up in the future. But how can anyone know what will happen 20, 30 or 40 years from now? We simply can't. Its possible that the nation might eventually switch over to some sort of flat tax system which would change the picture entirely. Your individual tax situation may not be the same as the national direction. So I think we really can't tell what taxes will do for us either as a nation or individually and its anyones guess.

The Roth IRA has a couple key benefits in my mind. Your tax burden is known. This means you'll have an easier time planning for your retirement future and no matter what happens decades from now, you'll know what your retirement account is really worth. Roths also allow you to access your money if you need it. While I really think you should never touch your retirement account unless its an emergency, it is nice to know its there if you do really need it. Its also quite possible that you will have funds in your IRA at the time of your death. Your estate heirs will benefit more if those are post tax dollars. [edit note: I had originally confused the estate tax implications for IRAs and I've now corrected that point]

Personally I think the traditional IRAs do offer tax benefits for most people. I generally think that people spend less in retirement. This means they'll have lower tax burden. This is a good reason to go with a traditional IRA.

So we come back to the basic question, are traditional IRA or Roth IRAs a better option? Since I think each has benefits for certain circumstances and we don't know what will happen in the future my answer is : Why not utilize a mixture of both traditional and Roth IRAs??

If you have both a traditional and a Roth IRA you have the flexibility to draw money out of the one that suits your tax situation at the time. Flexibility of using both could allow you to maximize your tax advantage in the future.

Here's some examples of what I'm talking about: Say 30 years from now you retire. You've got $500k in a Roth and $500k in a traditional IRA. Lets say that a new administration takes office in the White House and a tax bill goes through lowering taxes to help shore up social security. At that point you might start taking money out of the Roth IRA only and leave your traditional IRA alone. Then after 8 years the other political party regains office and the social security problems are resolved and they lower taxes again. Then it might make more sense to switch to using your traditional IRA funds and leaving the Roth funds alone.

Another example: Say you've got $100k in a Roth and $100k in a traditional. Maybe you've also got $100k in stocks you bought at some point. If you decide you want to sell off those stocks it might give you a high tax bill that year. If you pull money out of the Roth that year it won't push you into a high tax bracket. If you only had a traditional IRA then you wouldn't have this option.

Given the progressive tax nature you could use a combination withdrawals from a Roth and traditional IRA and maximize the situation so you still have zero tax liability. Given today's tax rates here is an illustration: Say you make $25,000 from social security each year and want to supplement that with $40,000 total withdrawals from your retirement. If you only had a traditional IRA then all your withdrawals would be taxable. Your total tax bill would be $4,241 for a married couple. That's about a 10% tax rate on the withdrawal ignoring social security. If on the other hand you had both Traditional and Roth IRA accounts and pulled $20,000 out of each then only the $20,000 from the traditional IRA would be subject to taxes. Since a retired couple has standard deduction and exemption and since your taxable income isn't too high your total tax bill would be almost zero at just $40. So in this situation, by finding an efficient way to take advantage of tax deductions and exemptions you would be getting a tax free withdrawal from your traditional IRA funds as well as your Roth IRA.

One big reason I think going with both forms of IRA is that it helps you hedge your bet against what taxes might look like in the future. If you went with a Roth IRA only and taxes happened to be lower in the future then you'd make out poor or if you went with a traditional IRA and taxes increased in the future it would also be worse. But if you've got some of each traditional IRA and Roth IRA then no matter if taxes went up or down you wouldn't be in the worst situation.

Going with a combination of both traditional and Roth IRAs helps you hedge your bets against future changes to tax rates. It gives you flexibility to withdrawal funds for the best tax advantage at the time given the rates or your individual financial situation. I think going with a combination of both traditional and Roth IRAs is a safe bet.

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