Roth IRAs tend to get a lot of hype, and for good reason: Because you pay the taxes upfront, your eventual withdrawals (assuming you meet the age and holding-period requirements—more on these below) are completely tax-free.
While we like “tax-free” as much as the next person, there are more times than you would imagine when a traditional IRA will put more money in your pocket than a Roth would.
Limits
For 2022, the combined contribution limit for both traditional and Roth IRAs is the lesser of
$6,000 ($7,000 for age 50 and over) or your taxable compensation for the year.1
Making the Decision on What’s Best
Example. Say that your tax rate is 32 percent and that you will invest $5,000 a year in an IRA and earn 6 percent interest. Should you put the $5,000 a year into a Roth or a traditional IRA?
Say further that neither you nor your spouse is covered by a workplace retirement plan, so you can contribute the $5,000 a year without worry because it’s under the contribution limits. 2
Traditional IRA
If you invest the $5,000 in a traditional IRA, you create a side fund of $1,600 ($5,000 x 32 percent).
On the side fund, you pay taxes each year at 32 percent, making your side fund grow at 4.08 percent (68 percent of 6 percent).
Roth IRA
Roth contributions are not deductible; this means no side fund, so your annual investment remains at $5,000.
Cashing Out
For the Roth, your marginal tax rate at the time of your payout doesn’t matter because you paid your taxes before the money went into the account. The whole amount is now yours, with no additional taxes due.
But for the traditional IRA, your current tax bracket matters a great deal. You have taken care of the taxes on the side fund annually along the way, but the traditional IRA (both growth and contributions) is taxed at your current marginal tax rate at the time you cash out.
The table below shows you how this looks with tax rates of 22 percent, 32 percent, and 37 percent at the time you cash out (winners are in bold):
You can see that the traditional IRA needs a low tax rate at the time of cash-out to win. But even in the 22 percent cash-out tax rate, the Roth wins at the 40-year mark.
Rate of Growth
What about your rate of growth? Do variances here change things any? Let’s take a look.
Here, we’ll look at different rates of growth for a fixed period (30 years) before you withdraw your money. Once again, we’ll consider three different marginal tax rates at the time you cash out—22 percent, 32 percent, and 37 percent.
In the scenarios above, the traditional IRA/side fund combo wins only when your marginal tax rate is lower at the time of withdrawal and only at the lower growth rates.
At higher rates of return—9 percent and 12 percent, in our examples above—the Roth still wins, even if you’re in a higher tax bracket when you withdraw your money.
Tax Factor
What’s going on here?
For starters, the side fund is not tax-favored in any way. Plus, taxes hobble your cash-out on the traditional IRA:
You pay taxes as you earn the money in the side fund.
You pay taxes on the accumulated growth inside the traditional IRA when you withdraw the money.
Look into the Crystal Ball
What tax bracket will you be in years or decades from now?
Unfortunately, there’s no way to know for sure. Nobody can predict what the federal government will be doing, tax-wise, down the line—though we do think it’s a safe bet that federal income taxes will not be abolished!
A better strategy is to look at your individual tax situation. While, again, nothing is certain, you may be able to anticipate likely life events—such as retirement, kids leaving home, mortgage paid off—that will affect your time of investment and tax bracket one way or the other.
The length of time you plan to keep the investment matters. As we see in the first table, given enough time, the Roth eventually catches up and passes the traditional IRA, even if your tax bracket is lower at the time you cash out.
Similarly, there’s no way to be sure what rate of growth you’re going to get over several decades of investing. A very rough (but common) benchmark is a 10 percent return, pre-tax 9—which, again, tends to favor the Roth in our example above.
But Wait! There’s More…
Setting aside for the moment the Roth advantages we’ve discussed above, a Roth offers other additional perks.
No required minimum distributions (RMDs). When you have a traditional IRA, the IRS requires you to start taking distributions by April 1 following the year you turn 72, and by December 1 in subsequent years.
The withdrawals are (a) mandatory and (b) included in your taxable income, with the exception of basis.10 Because there is no RMD requirement with a Roth, it’s an excellent vehicle for continuing to grow your wealth and, if you so desire, passing it on to your children.
Longer period to contribute. Not only do you have to start taking RMDs when you hit 72 with a traditional IRA—but you’re also barred from making additional contributions when you hit that magic age.
With a Roth, you may contribute at any age, as long as you have taxable compensation. (There are income limits 11 for Roth contributions, but you can get around these using the backdoor strategy.)
More flexibility with withdrawals. You can withdraw your contributions to a Roth anytime, without penalty. And if you’re over age 59½, distributions of earnings from your Roth are also not taxable—because, again, you paid the taxes up front.
You just need to satisfy the five-year waiting period requirement, meaning the distribution must occur after the five-year period starting with the first taxable year for which a contribution was made to the Roth. 12 With a traditional IRA, both deductible contributions and earnings are taxed at the time of withdrawal.
Traditional IRA Advantages
Is there ever a time a traditional IRA would be better? Maybe. Here are two possible reasons.
Lowers your taxable income at the time of contribution. Because contributions to traditional IRAs are generally deductible, they reduce your taxable income at the time you make them.
If you’re in a high tax bracket now, or if you’re looking for a last-minute deduction, this may be something worth considering. But remember—you need to invest that money in the side fund to have even a crack at coming out ahead with the traditional IRA.
If your plan is to blow the tax savings on doughnuts, you’re better off with a Roth.
State income tax considerations. If you live in a state that charges high income taxes, but you could see yourself moving in the future to a state with lower (or zero) income taxes, a traditional IRA could let you defer those taxes—and possibly avoid them entirely in case of a move.
Different states have different laws on the deductibility of IRA contributions as well as on the taxation of retirement plan distributions, so make sure you’re clear on the rules in both your current and future locations.
Takeaways
Roth IRAs offer a lot of tax advantages for your future self, while traditional IRAs give you the tax breaks now. The trade-off is an uncertain tax liability decades from now, possibly after you’ve stopped working.
And given enough time and/or a high rate of return, you’re better off with a Roth anyway.
If you really want the current deduction, a traditional IRA may make sense. It may also be a good choice if you anticipate moving from a high-income-tax state to a more tax-friendly locale.
But remember—you must actually invest the side fund money to create even a fighting chance for your traditional IRA to tie or beat a Roth. Don’t take your deduction and blow the tax savings on doughnuts.
1 Notice 2021-61.
2 IRC Section 219(a).
3 Remember, a 6 percent rate of growth is actually only 4.8 percent for the side fund, post-tax.
4 All the totals for the traditional IRA, in both tables, represent the sum of the post-tax IRA amount plus the side fund amount.
5 2.04 percent, post-tax, for the side fund.
6 4.08 percent, post-tax, for the side fund.
7 6.12 percent, post-tax, for the side fund.
8 8.16 percent, post-tax, for the side fund.
9 See, e.g., this report from the Urban-Brookings Tax Policy Center, FN 16, reported in Tax Notes on August 24, 2018.
10 IRC Section 72(t)(1).
11 Notice 2021-61.
12 IRC Section 408A(d)(2)(B) 2018.
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