In the thousands of words I’ve written on this website, the tons of emails I’ve sent back and forth with readers, and the millions (and billions!!) of article comments, there’s one question I easily get asked more than any other.
Nope, it’s not just how exactly I plan on retiring by age 37. Nobody really seems to care for the details about how I’ve saved $150,000 before my 27th birthday either.
$10 internet is a close second.
I’d even thought for sure there would be more interest about that time I saw Tom Brady on the ski slopes…
Nope, far and away the number one question I get from readers is:
Should I invest in a Roth or Traditional IRA?
A-ha, the million-dollar question.
Well, we can hope this is a million-dollar question. In reality, it’s more like a couple thousand-dollar question, and for most of us, the answer is so insignificant that it’s not even worth fretting over.
Seriously.
I know, I know… For years you’ve watched Financial Advisors in their fancy suits, far too big wristwatches, and far too shiny cufflinks parade in front of your employer’s annual retirement seminar, rambling on endlessly about the complex differences between the two retirement accounts.
Yet the more he talks, the more confused you feel. Isn’t that amazing?
(PS – here’s a safe rule of thumb: if you’re a reasonably intelligent person, and what should be a simple explanation still makes no sense to you after multiple descriptions… someone is probably trying to intentionally confuse you. They’re either trying to sell you something or make themselves look smarter.)
Here’s the straight truth:
The differences between Roth and Traditional retirement accounts don’t really matter all that much.
Here’s why:
Roth vs. Traditional Retirement Accounts
Quick textbook review:
Traditional Account: Is funded with pre-tax dollars. In other words, your contributions are tax free, and they reduce your taxable income. The account then grows tax free, BUT you have to pay taxes when you cash out in retirement. In layman’s terms – you pay taxes on the back end.
Roth Account: Paid with after tax dollars, but the account grows tax free, and can be withdrawn at retirement without paying any taxes. Translation – you pay taxes on the front end.
(Both options are better than nonretirement (aka taxable) accounts, where you pay taxes on the front end, back end, and even some of the middle…end)
But still, this sounds like a tough choice, right?
Let’s start with a simple example that shows just how needless all the worry about which basket to put your eggs in really is. Assume:
- You’ve just started saving your money, and you’ve earned $1,000 to invest into a retirement account.
- Your annual income puts you into the 25% tax bracket.
- And to simplify our example, you’re also an exceptionally unlucky investor, and both investments return 0% over your lifespan.
With the traditional account, you receive an income tax deduction up front, but you’ll eventually owe taxes on the withdrawals. The process looks like this:
Under option B, the Roth account is funded with after tax dollars, but you don’t have to pay taxes in retirement. The Roth process looks like this:
Hey wait! Both options gave us the exact same amount of money.
Exactly.
If your tax bracket stays the same, Traditional and Roth accounts leave you with the exact same amount of money.
“Okay Money Wizard, but what if your investments, you know… actually make money?”
Good question. Counter-intuitively (or maybe intuitively, if you’re better at math than I am) your retirement account’s rate of return doesn’t impact whether the Roth or Traditional account is a better choice.
Yes, even if you earn an astronomically unrealistic 1 million percent per year, you’ll have the same amount of money in your pocket, no matter which type of retirement account you choose.
I could run through another boring math example to prove this, but just trust me.
(You’re not trusting me are you? Without busting out numbers, the process works like this: If you choose Traditional, you do actually write the IRS a larger check at the end, but this larger tax burden is canceled out by the benefit of starting with a larger initial investment. If you choose a Roth, your smaller, after-tax investment can’t grow as large, but you don’t have to pay any taxes in the end, leaving you with the exact same amount of money in your pocket.)
So, when does one retirement account make for a better choice than the other?
In the previous example, the results were the same because your tax bracket stayed the same. Therefore, the tipping point for Roth vs. Traditional decision is whether you expect to be in a higher or lower tax bracket today or in retirement.
If you expect to be in a lower tax bracket in retirement, you’d rather not pay taxes today. Waiting to pay taxes until you’re in a lower tax bracket makes sense.
Thanks, captain obvious.
If you’re in a lower tax bracket today than you will be in retirement, paying those taxes now makes more sense.
This should be intuitive, but let’s look at two quick detours to prove this point. Feel free to skip these next two examples if you get the point and/or are already math’ed out.
Assume:
- You have that same $1,000 to invest, and your tax bracket today is 25%.
- In retirement, you expect a lower income to put you into a 15% tax bracket.
Your two options are:
- Traditional account: you defer your 25% tax rate, and invest $1,000 today. You withdraw $1,000 in retirement and pay 15% taxes.
- Money in your pocket at retirement: $850
- Roth account: You pay a 25% tax rate today, and invest $750. You withdraw $750 in retirement and pay no taxes.
- Money in your pocket at retirement: $750
Winner? The traditional account, because you deferred taxes while you were in a higher tax bracket.
Now imagine the same scenario, but with a 25% tax bracket today that is raised to 33% in retirement.
- Traditional account: Defer 25% taxe rate, invest $1,000. Withdraw $1,000 in retirement and pay 33% in taxes.
- Money in your pocket: $670
- Roth account: Pay a 25% tax rate today, invest $750. Withdraw $750, pay no taxes.
- Money in your pocket: $750
Winner: Roth account. This makes sense. Paying taxes while in a lower tax bracket is intuitively a good thing.
Why The Retirement Account Debate Isn’t Worth Your Stress
All those calculations and textbook answers aside, the differences between the two choices still aren’t really worth stressing over.
Why? Because the two retirement accounts are mathematically very similar, and nobody can predict the future anyway.
I would guess most people will earn more income (and be in a higher tax bracket) during the time in their life while they’re slaving away 40+ hours every week, rather than when they’re 70 years old working as a Walmart greeter because they’re tired of playing too much bingo. This is a valid argument in favor of the traditional retirement account.
On the other hand, maybe you’ll read so much of MyMoneyWizard.com and make so many brilliant investments that your retirement income blows your ordinary income out of the water, in which case the Roth would probably leave you ahead.
The point is, there’s a lot of guess work.
Even if you can perfectly predict your future income, do you know what tax rates will look like 30, 40 years from now? I sure don’t.
40 years from now, an A.I. version of Donald Trump’s hair could be serving his 10th consecutive term, slashing income tax rates down to a flat 10% across the board. Or equally likely, Bernie Sander’s robot grandchildren could be running the country and rewriting the tax code for a 50% income tax rate.
The point is, it’s a guessing game. A guessing game that people love to stress over. The unplannable that everyone wants to plan for. (Totally off topic, but spell check is telling me unplannable isn’t a word. I say nonsense! What do you think?)
So relax, the choice between a Roth or Traditional account won’t be the difference between living in poverty or swimming in bathtubs of dollar bills during your retirement years.
Personally, I max out both, which diversifies my decision a bit. The traditional account is my main priority, and what I use for my $18,000 of annual 401K contributions. I have a couple reasons for this decision:
- I’m planning on retiring early and living a low maintenance lifestyle, so I don’t anticipate my retirement income to exceed my working income.
- The tax code in the United States is highly favorable to investment income over working income. For example, a married couple can earn $75,300 in dividend income without owing any taxes.
- Traditional accounts allow for taking advantage of Roth IRA conversions for early retirees.
This is me talking as a guy who’s not wearing a fancy suit and has nothing to sell you – No matter your situation, as long as you are saving and investing in either account, you’re on the right track. There’s no sense stressing over the minutia and trying to predict the unpredictable. It will all work out.
🙂
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Great post, Money Wizard.
I personally have both, a Traditional 401(k) and a ROTH IRA, in order to “diversify” because we don’t have what the future holds.
And as you said, it’s better to hold a Traditional or a ROTH than a Taxable Account as there won’t be as many “middle” taxes.
Thanks for the compliment.
It looks like you have the exact same setup as I do. A Traditional 401K with a Roth IRA. I too like the diversity.
Awesome simple comparison. I also get this question all the time. It amazes me how complicated people think this stuff is. Demystification isn’t rocket science, but I am convinced the “suits” want us to think it is.
BTW, unplannable is totally a word. My Apple iPhone says so. 😉
Mrs. Mad Money Monster
I knew it! Unplannable HAS to be a word.
Hi Money Wizard,
I’ve enjoyed your site; I’m also a twentysomething hoping to retire as a thirtysomething.
Like you I max out my Roth IRA and my Traditional 401k for tax-strategy diversification. It’s worth noting that the Roth IRA lets you withdraw your contributions without penalty, so it’s a more flexible option for young people (it makes a very good way to save for a down payment, for instance). This also makes it a safer option for early retirees who may need the money before age 60 (Its far more likely that the IRS ends the IRA conversion ladder than that it slaps a penalty on Roth withdrawals). I think that, especially if you already have a traditional 401k through work, the Roth is the clear choice for this reason.
Good point about the free withdrawal of the Roth contribution, especially for down payments.
Thanks for pointing this out. I’ve been working on a blog post on the exact same topic (haven’t posted it yet) because I feel so many investors are misinformed when it comes to the difference between Roth vs. Traditional. All that really matters is your tax rate now vs your tax rate in retirement.
So true, the two retirement accounts definitely have a lot of myths and misinformation out there.
very informative, thank you – – with income limits on the Roth that may factor into which one you decide on — over at PoF he just posted a great article on how to create a Backdoor Roth.
Good point about the income limits. For anyone curious, here’s a good overview: http://www.rothira.com/roth-ira-limits
One takeaway I see here is not to fall into paralysis by analysis. You see this happen so much. People nitpick every little investment choice made, to the point where you basically don’t even want to do it.
One thing I sometimes think about is whether to contribute to a traditional IRA when you expect your income to rise by quite a bit in the future. For a lot of folks anticipating a high income growth, I often suggest keeping that trad IRA space empty. It makes it much easier to utilize a backdoor Roth in the future.
So true. Paralysis by analysis might be the average investors worth enemy.
Great point about the backdoor Roth.
Great post! I can’t stand it when “experts” make sweeping generalizations that one is definitively superior.
My wife and I gross over the limit to contribute to a Roth IRA, so we both max out our traditional 401ks, and with the subsequent tax deductions, we move back into eligibility for contributions to the Roth IRA (but still above the traditional IRA limits) so we max out the Roth as well.
Easy peasy! Perfect? Probably not, but it works for us. It’s just too dependent on personal situation to give a right/wrong answer., and like you say, it’s not going to make or break your retirement.
Agreed. I think a lot of supposed experts, especially in those work sponsored retirement seminars, like to pretend as if they’ve cracked the code and can say once and for all which account is better. A weak ploy to try to earn their speaking fees, in my opinion.
Glad to hear it’s working out for you guys, and it sounds like you’re killing it.
Here is a link to a post that shows the “boring math” in an Infographic: https://www.ninjapiggy.com/blog/what-ira-investors-must-know
Thanks for the infographic!
There are a bunch of unknowns, but is it possible that deferring into a traditional 401K or IRA could potentially lower your tax bracket? Aren’t the higher taxes only paid on your income above certain income levels? Either way, if your tax bracket is potentially lowered from pretax contributions, paying taxes should theoretically spread your income throughout your life, meaning you’d be in a overall lower tax bracket, not considering any potential changes to tax code. This kind of makes the traditional 401k/IRA decision easy for me. Any other assumptions about the future are just that…a guess.
I meant “contributing pretax should theoretically spread your taxable income throughout your life….”
Interesting thought. I could see it working like you say in certain situations, and essentially smoothing out the income over a lifetime. The only way you’d run into trouble is if your retirement income was higher than expected, and by deferring the income, the distribution in retirement bumped you to a higher bracket than during your working years.
If I’m understanding you right, you’re essentially operating under the assumption that your income (and thus tax bracket) will be lower in retirement than during your working years, which is why preferring the traditional 401K/IRA in your case makes perfect sense.
Especially for high savings rate early retirees, your tax bracket should almost definitely be lower in retirement if only for the reason that pre-tax account contribution limits will keep your taxable income high during your working years. I think the same concept would still apply to people who only save a modest 15-20% of their salary though. Generally, unless you have low income to the point where you’re barely being taxed at all, you should be making traditional contributions. In my opinion, the creation of Roth contributions was just a way for the government to rob future generations of tax income.
I had always assumed the Roth had been around forever. I was pretty shocked to learn it wasn’t created until 1997, which does make me suspicious that the Roth creation was nothing more than a desperate move by our financially irresponsible government to collect more taxes NOW.
Intergenerational theft, and the baby boomers have quite the history with it.
“Yes, even if you earn an astronomically unrealistic 1 million percent per year, you’ll have the same amount of money in your pocket, no matter which type of retirement account you choose.
I could run through another boring math example to prove this, but just trust me.”
Can you educate me on this? I actually have a different view. My view is that Roth IRA will come ahead (as of giving you more money by paying less tax) on the case where your tax bracket remains the same.
Let’s make a twist on that very simplified example. You invest $1000. You are at the same tax rate when the contribution and the distribution is made.
So your example is correct. You paid both $250 in both cases.
But what if the investment actually give you a return. Let’s say the return is 100% over your career (simplified).
So for Trad IRA, you put $1000. When you retire, you have $2000 (100% return rate). Pay withdraw all of them, and pay 25% * 2000 = $500.
For Roth IRA, you put $1000, pay $250 now. But when you retire, you can withdraw $2000 tax-free.
In the first case, you ended up with $1500, and on the second case, you have $1750.
I agree that this simplified case ignore a lot of factors. But it does show that choosing the right type of IRA can optimize your return, even if there is no one-size-fits-all approach.
Remember, Traditional contributions are pre-tax. The problem with the above comparison is that in order to invest $1,000 into a Roth IRA, you’d have to actually earn $1,333.33. The $1,333 then gets taxed down at 25% to $1,000.
This means your options would actually be $1,333.33 invested in a Traditional IRA, or $1,000 invested in a Roth. And once we make that adjustment we see:
Traditional IRA: $1,333.33 with a 100% rate of return grows into $2,666.66 in retirement. Pay 25% taxes at withdrawal = $2,000 in your pocket.
Roth IRA: $1,000 with a 100% rate of return grows into $2,000 in retirement. Withdraw $2,000 tax fee = $2,000 in your pocket.
Your comparison is fair only if the income is somehow tax exempt. Yes, if you ever get some sort of tax exempt gift or inheritance from a rich uncle, a Roth really does provide a sort of free lunch. For everything else, including earned wages, the growth rate will never affect the final amount of money in your pocket.
“Remember, Traditional contributions are pre-tax. The problem with the above comparison is that in order to invest $1,000 into a Roth IRA, you’d have to actually earn $1,333.33. The $1,333 then gets taxed down at 25% to $1,000.”
This is where I got it all wrong. With Roth IRA, you get to contribute less because of tax that would otherwise get invested in Trad IRA.
Thank you for the clarification and enlightenment.
Exactly.
All the rules and stipulations can definitely make a head spin.
If you’re in it for the long game, a Roth IRA will almost always be your best bet. Once you get to the point of maxing it out, I would then start to look at other investment opportunities. But otherwise Roth IRA’s are like the rich man’s investment vehicle made for the middle class.
What reasons do you think make a Roth better than a traditional IRA?
I realize this is probably too late and wanted to add why I went with a ROTH. RMD’s. (Required Minimum Distributions). I have some other investments that pay my living expenses with enough left over to continue to invest, don’t really need my IRA accounts. They are my “emergency fund” since I’m already old enough to withdraw without penalty. Now, I just let the funds simmer until needed and I don’t have to worry about the RMD’s putting me into an even higher tax bracket. I realize this is not something most people would want to consider and it could help a few.
Interesting. Thanks for sharing!