Reader Question: Roth vs. Traditional IRA

Reader Question Roth vs. Traditional IRA _ AnythingYouWantBlog.com

I am so excited to share another reader question with you today! Remember, you can ask me anything on my Ask Ali page. I’d love to hear from you!

Today’s question comes from another dear friend of mine who left the workforce for a few years to pursue a graduate degree. She has some funds in a 401(k) from her previous employer and is trying to figure out if it is better to rollover her funds into a Roth IRA or a traditional IRA.

She asks: “What are the pros and cons of Roth vs normal IRA? Is it worth it to pay out taxes now, especially since I expect I’ll be over the limit and unable to contribute once I finish grad school in 2 years? And if it’s as good as it sounds, shouldn’t every 20-something making much less now than we will in the future be taking advantage of it?”

The short answer: Yes!

I have always been a huge fan of the Roth IRA. It is my personal opinion that it is the best investment tool available and everyone who can should take advantage of it. I personally have maxed out my Roth IRA since I began working, and I would encourage everyone who is eligible to invest as much as they can in a Roth IRA.

What is an IRA?

An IRA is an Individual Retirement Account. Unlike a company-sponsored 401(k) or equivalent, an IRA is something that you can open and maintain completely on your own. Like other investment accounts, an IRA is not in and of itself an investment, it is simply one type of account through which you can invest. You can open an IRA at any number of financial institutions, including traditional banks and investment banks both online and off. Once you have an IRA and fund it by putting money into it, you can then invest that money in any number of investments, from CDs to stocks, bonds to mutual funds.

IRAs come in two flavors: traditional and Roth. The key different between these two types of IRAs is in the tax treatment. A traditional IRA is funded with pre-tax income. Yearly taxes on earning are deferred and are only paid when you withdraw the funds, which are treated as ordinary income, in retirement. A Roth IRA is funded with post-tax income and is able to grow tax free, meaning that no taxes are due when you withdraw funds.

There are a few other differences between traditional and Roth IRAs.

  • Income limits. You may only contribute to a Roth IRA if your income falls below certain limits, which vary depending on your age and filing status. Traditional IRAs have no income limits.
  • Age limits. You can contribute to a Roth IRA at any age (even in retirement) but cannot contribute to a traditional IRA after age 70.5.
  • Distributions. Traditional IRAs have required minimum distributions starting at age 70.5, whereas Roth IRAs have no required minimum distributions.

There are also many similarities between traditional and Roth IRAs.

  • Financial institutions. Both can be held at most financial institutions.
  • Contribution limits. Both have a combined yearly contribution limit (currently at $5,500). This means that you can contribute a maximum of $5,500 to all IRAs (not including rollovers), not $5,500 to each a traditional and Roth IRA.
  • Withdrawal penalties. Both have penalties for early withdrawals, although for a Roth IRA you may withdraw you contributions penalty free in certain qualified circumstances, such as for the purchase of a first home or for educational expenses. Note that this only applies to contributions, not income generated from those contributions (i.e. if you invest $1,000 and five years later it is worth $1,100, you can withdraw the $1,000 penalty free but not the $100 that you’ve earned on that money).

So which is better, a Roth IRA or a traditional IRA?

If you are eligible for an IRA, I think that in almost all cases a Roth IRA is the better choice. The fact that you can pay taxes now and never again in the future is HUGE. This is especially true if you are young and expect your income to rise in the future. If your income is low, you’ll be in a low tax bracket and may not have to pay much in taxes to begin with. If you expect your income to rise in the future, there is a huge benefit to paying taxes now instead of when you make withdrawals in retirement.

It also doesn’t hurt that tax rates are still pretty low compared to historical averages. Who knows what tax rates will do in the future, but if you’ve got your money locked in to a tax-free vehicle, you’re likely to be in good shape no matter what happens down the line. One thing that I have worried about from time to time is the possibility that the tax-advantaged status of Roth IRAs might change in the future. I’ve researched this quite a bit and while anything is possible, I’ve seen no historical evidence to indicate that the government might take this advantage away in the future.

Another reason that Roth IRAs are particularly awesome for young people is the income limit. Chances are that when you’re just starting out, your income will be well below the limit. Take advantage of this! Hopefully your income will go up over time and eventually you’ll become ineligible for a Roth IRA (this is a pretty good problem to have!). If you contribute now, you’re paying low taxes on your low income, giving yourself a really really long time for that money to grow, and getting your money in to a tax-advantaged account while you can. It’s a win-win-win!

Traditional IRAs are good, too

If you’re not eligible for a Roth IRA, that doesn’t mean that you shouldn’t contribute to an IRA at all. Traditional IRAs are also a great tool, and I will always argue that saving something is better than saving nothing!

Another thing to consider if you earn too much money to be eligible for a Roth IRA is a Roth IRA conversion, sometimes called a “backdoor” Roth IRA. This is when you fund a traditional IRA and then roll it over into a Roth IRA. There are no income limits for rollover Roth IRAs, so this is completely legal, although it may have substantial tax implications due to the different ways that Roth and traditional IRAs are taxed.

What should my friend do?

Based on my friend’s specific circumstances, it sounds like a Roth IRA conversion is definitely the right choice. She is making a relatively low salary right now, which means that she is paying a very low tax rate. She’ll have to pay some taxes to make the conversion from a 401(k) to a Roth IRA, but it will be less now than it would be at a time when she is working and making her full salary. The Roth will also give her a lot more flexibility with her money, allowing her to use some of her contributions for a down payment on a home or another qualified expense in the future.

I would also argue that, if the income is available, she should take advantage of being under the Roth IRA income limit while in school to make additional contributions to her Roth IRA. She’ll likely become ineligible in the future, and the benefits of having more money for retirement growing tax free are huge.

What did I do?

Funnily enough, I’ve found myself in nearly this exact situation in recent weeks. As I’ve mentioned before, I recently left my job of five years and have started at a new company. This left me with both a state pension payout and 457 (public sector equivalent to a 401(k)) to deal with. So what did I do with my money?

I didn’t follow my own advice! As much as I love Roth IRAs, I knew that a Roth IRA conversion was not the right choice in my situation. Unlike my friend, who is rolling over funds at a time of relatively low income, I am rolling over funds at a time of my highest income to date. Because of this, the tax implications of transferring my money into a Roth IRA instead of a traditional IRA were too steep. I elected to transfer my funds into a traditional IRA so that I can avoid paying taxes.

I’m still below the Roth IRA income limit, and I have already fully funded my Roth IRA for the year, so I’m not abandoning my Roth altogether. For me, at this time in my life, a Roth IRA conversion simply wasn’t the right choice. I’m sharing this to illustrate that all of this is very dependent on circumstances, and there is no one-size-fits-all answer when it comes to personal finance.

So what do you think – Roth or traditional IRA?


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12 thoughts on “Reader Question: Roth vs. Traditional IRA

  1. A 457 isn’t actually the public sector equivalent of a 401(k)! If you roll it over to an IRA, you’ll lose its special benefits of being able to withdraw anything after you’ve left your employer. Withdrawals from them aren’t subject to the 10% penalty like a Traditional IRA is.

    https://www.bogleheads.org/wiki/457(b)

    I would also be careful rolling anything over to a Traditional IRA if you think that you might be above the Roth IRA income limit at some point in the future. With a MBA and living in a HCOL area, that is reasonably likely.

    • That is a great point! I wasn’t really considering that benefit as I have no plans to withdraw the money before retirement, but that is an important consideration.

  2. For her, a Roth IRA is the best bet. A traditional IRA is best if you expect to be in a lower tax bracket in retirement. That’s why my wife and I are contributing to the Traditional now. It’s safe to assume that tax rates overall will be higher in the future, but we can only really go by the facts today. And the fact for us is that we are in the 25% bracket now and will be in the 15% bracket in retirement.

    • Good point – I’m also expecting that in retirement I’ll be in a lower tax bracket than I am now, which was another reason that a traditional IRA rollover made sense for me.

  3. I agree, Roths are the best. I understand the logic behind the IRA: pay tax later when it’s (probably) going to be lower, and get the deduction now. But I don’t buy it. And a professor once showed us a spreadsheet that showed that, in almost all cases, a Roth would still yield better results.

    I’ll be opening a SEP next year, so I’ll max out the Roth and then start on the rest.

    • Agreed. I generally feel like I’d rather get things like taxes out of the way now instead of waiting to see what they might be like in the future.

  4. Bob says:

    Very interesting! If it’s so lucrative to convert traditional IRA money to Roth IRAs, why doesn’t everyone do it? Just cause they’re dupes??

    • Haha good question! I think that generally people don’t want to pay more than they have to now (people aren’t usually so good with delayed gratification), so an immediate tax break might be more appealing than a future tax-free withdrawal. Also, surprisingly many people don’t have an IRA at all (as much as 80% of people according to some sources), which is kinda sad. Finally, the mechanics of a “back door” Roth IRA for those who are ineligible due to income restrictions might seem too complicated, and again the tax burden could potentially be high.

  5. Choosing between a traditional IRA and a Roth IRA all comes down to what your current and future tax bracket will be. I agree if you are just starting a career or you are a student, a Roth might be best for you since you think you will make more money later in life. Speculating about the future of taxes is impossible. Since I am firmly in the 25% tax bracket and have options to contribute to a 401k, Roth, or traditional IRA, I like to practice ‘tax location diversification’. The tax break a traditional IRA provides to someone like me in the 25% bracket is hard to pass up, but since I get the $18k deduction from my 401k contributions I have chosen to max the Roth instead of the traditional. The Roth just provides too much flexibility for me to pass up.

    There probably is not a ‘right’ answer to Roth vs Traditional for everyone, as everyone’s situation and preferences differ.

    • Great points! I totally agree that the flexibility of the Roth is really appealing, and that there isn’t one right answer for everyone. It depends!

  6. Sarah says:

    Thanks so much for answering my question, Ali! This was very helpful, and I think you’re right that a Roth conversion is the right choice for me, even if it means I have to pay out some taxes now.

    One thing worth noting when I took a look at the qualified circumstances for withdrawals you linked to is that you have to have the account for at least 5 years before you can withdraw for a house down payment without penalty. I am kicking myself for not doing this earlier! I think it’s likely I may want to buy a house in the next five years, so I’ll have to balance my savings between my Roth IRA and my other investment account.

    • No problem – it was fun to answer! That is a great point – I didn’t want to get into every nitty gritty detail here but there is definitely a benefit to opening a Roth sooner than later, even if you only fund it with a little bit of money.

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