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To Roth or Not to Roth?

Which is best for saving for retirement - traditional or ROTH IRA?

The IRA may be one of the greatest wealth building inventions of all time. But nothing's simple and today savers have a choice. It's all the more important because today the ROTH option is not just available in IRAs, but in many employer based 401k plans.

In my view, for those savers who are eligible to make a deductible contribution, the traditional IRA is by far the better vehicle. This is because the amount saved on taxes from the deduction can be added to the total contributed - producing a larger IRA balance! And isn't a larger balance the idea? 

I find many people have the idea the ROTH is the better option. There are several reasons for this:

  1. The ROTH is newer, having been established by Congress in 1997 based on a proposal from Senator William Roth. By contrast, the traditional IRA was enacted way back in 1974. Newer is generally better in the cycle of product development. But not always - remember the case of New Coke versus Classic Coke?
  2. The ROTH has a special name. Enhanced products often get catchy monikers. Look at automobiles. In the 1970's there was the Chevelle - or the top of the line "Chevelle SS." The special name implies the ROTH is special. But the ROTH is not a car!
  3. Most importantly, ROTH IRAs have the incredible attribute that distributions at retirement are tax free. Now that's amazing! Tax Free distributions are kind of like the holy grail of retirement tax planning. 
How can the venerable, old fashioned traditional IRA compete?

Consider the hypothetical case of a 30 year old saver. They've worked hard and done their budgeting and determined they have $4000 they can put into an IRA - not a penny more. If they put $4000 in the ROTH, the $4000 is an after tax contribution. The funds could grow until age 70 when they start distributions, and at that point they come out tax free. Great.

But with the traditional IRA, the $4000 is tax deductible. Assuming a 25% bracket, there is a net tax reduction of $1000. This may be added to the original $4000 for a contribution of $5000. So $5000 goes in the IRA - on day one the balance is 25% greater. This larger amount can now grow and compound all the way to retirement.

At that point the distributions are taxable as ordinary income. Isn't that a drawback? In my experience, not so much. First, IRA distributions occur by definition at retirement. Thus, there is no employment income. This likely means a lower tax bracket. Second, IRAs are not withdrawn all at once. They are taken a little each year, with distributions initially as low as 4%, climbing in later years perhaps to 8%. So the tax is pay as you go with only a portion subject each year. Not a bad tradeoff for all those years using money saved from deductible contributions to help build the IRA balance.

Not everyone is eligible to make a deductible contribution to a traditional IRA though. In 2019, the cut off for a single filer covered by a retirement plan at work is $64,000 or less modified adjusted gross income. The ROTH is much higher - $122,000 MAGI. (I regard the tighter limits on qualifying for a traditional IRA as an indication I am not the only one who thinks the traditional IRA is more advantageous.)

Here's a rule of thumb: use a traditional IRA if eligible for a deductible contribution. If not, then contribute to a ROTH if you qualify based on the higher income limits.

This is all good news. We have to make choices - often between something good and something perhaps not so good. A happy thought: whether you choose to contribute to a traditional IRA or a ROTH, you're making a great decision for your future.

Note: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Contributions to a traditional IRA may be tax-deductible in the contribution year with current income tax withdrawal due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.

The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being open for 5 years whichever is later may result in a 10% IRS penalty tax. Future tax laws can change at anytime and may impact the benefits of Roth IRA. Their tax treatment may change. 

Investing involves risk and including loss of principal. No strategy assures success or protects against loss. LPL Financial does not provide tax advice. Clients should consult with their personal tax advisors regarding the tax consequences of investing.