Traditional or Roth IRA - Which is Best for You?

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Last updated on February 14, 2019 Comments: 16

I wish Roth IRAs had been around when I got my first real job working at a local Radio Shack as a teenager. Years later, it’s hard to know what would have gone through my mind if someone had tried to talk me into investing those first meager paychecks. But now looking back, it’s easy to see what could have been had I done just that in a traditional or a Roth IRA.

Unfortunately, Roth IRAs weren’t invented until I was in college. But now, everyone–including teenagers working their first job–has to make the decision between a Roth IRA and a traditional IRA. At least, they should make this decision, since everyone should invest in an IRA as early as they possibly can.

So if you’re getting ready to choose, or change, your IRA, which should you go with? A Roth or a traditional? Here’s what you need to know.

Understand the Differences

Before you can make this decision, of course, you need to understand the difference between a traditional and a Roth IRA. They’re similar in that they both grow with tax-free interest. This gives you a big boost in savings potential versus fully-taxable investment accounts.

Of course, you have to pay taxes on your money at some point. And that’s where the difference lies.

With a Roth IRA, you put in after-tax money, but you withdraw it later tax-free. With a traditional IRA, you put in pre-tax money, but you pay income taxes on the withdrawals later. In short, choosing between these accounts is as simple as figuring out when you want to pay the inevitable taxes.

Except that it’s really not all that simple. If you have a much higher income tax rate now than you will in retirement, a traditional IRA can save you money. If the opposite is true, the Roth is where you want to invest. But the Roth also has a couple of other advantages and caveats worth considering. We’ll break them down below.

Know Whether You Can Choose a Roth

There are limits on who can contribute to a Roth IRA and how much you can contribute. In 2018, if you’re married filing jointly with a modified adjusted gross income of less than $189,000, you can contribute up to $5,500 to a Roth IRA (plus an additional $1,000 if you’re 50 or older). If your income is above $199,000 for the year, you cannot contribute to a Roth IRA at all. And if it’s between those figures, you can contribute a reduced amount based on a sliding scale.

You can check out the limits for other tax filing situations here. But basically if you’re a high income earner, you may not qualify to open a Roth IRA at all.

There are somewhat similar rules for taking a tax deduction for your traditional IRA contributions if you’re a high income earner. If you’re also covered by a retirement plan at work and open a traditional IRA on the side, you may not get to take the income tax deduction for your contribution. You can learn more about that here.

So if you already know that you don’t qualify income-wise for a Roth IRA, feel free to quit reading this article now. Just go open a traditional IRA (and make sure you understand the deduction rules for it!).

Try to Estimate Your Tax Rates

One of the problems with trying to figure out this Roth vs. traditional equation is that no one has a crystal ball. But if you generally think your tax rates are lower now than they will be in retirement, a Roth is what you want to go with. If you think, on the other hand, that you’ll have a higher tax rate now than later, you’ll likely be better off with a traditional IRA.

Young professionals and even teenagers are particularly well-suited for a Roth IRA. They’re likely in the lowest tax bracket of their lives with a lower income starting out. A tax deduction for contributing to a traditional IRA won’t mean much for them. But in retirement not paying a much higher tax rate on withdrawals could make a big difference.

Of course, the variables in this equation could change. Congress could change the rules for Roth IRAs. And some economists think that tax rates should be much higher in the future.

But do the best you can when making these estimates based on your current situation and the current laws. At worst, you’ll lose some of your interest earned because you made the wrong bet. But it’s better to start saving something–anything–than to be paralyzed by trying to figure out exactly what’s going to happen in the future.

Look at Potential for Early Withdrawals

One other benefit of a Roth IRA that may factor into your decision separately from the tax situation is that you can withdraw from these accounts early in more circumstances.

With a traditional IRA, you’ll pay a penalty for most withdrawals before you are age 59 ½. So you’ll pay income taxes on the withdrawal plus a 10% early withdrawal penalty. This is the case unless you meet one of the following requirements:

  • You have unreimbursed medical expenses for more than 10% of your AGI for the year
  • The distributions are more than the cost of your medical insurance during a period of unemployment
  • You become totally and permanently disabled
  • You’re the beneficiary of someone else’s IRA after they die
  • The distributions aren’t more than your qualified higher education expenses
  • You use the distributions to buy, build, or rebuild your first home
  • The distribution is because of an IRS levy of your plan
  • The distribution is a qualified reservist distribution
  • You’re receiving distributions in the form of an annuity

So, basically, you can use your traditional IRA to cover certain medical and educational expenses, to pay for your first home, or meet other strict requirements.

With a Roth IRA, though, you get a lot more flexibility because you can withdraw your own contributions at any time and for any reason. However, the interest earnings on your account are subject to similar limitations to the traditional IRA. You can avoid penalties–though not taxes–if you’re under age 59 ½ if you use the money for education or first time home purchases, need to pay for certain medical or health insurance expenses, or meet other requirements.

All of that to say that if you’re hoping to spend a few years saving up for a home, a Roth IRA could be a good option. You can stash the money there, and then take out your contributions when it’s time to buy. You’ll do this without paying any taxes or penalties. And the interest earnings in the account can continue to grow tax-free until you’re 59 ½ and ready to withdraw them too–without paying taxes on them.

Bottom Line: Just Start Saving

Deciding between a traditional and a Roth IRA can be tough, for sure. But once you crunch the numbers, the important thing is just to start saving. If you’re young and just starting to work or beginning a career, a Roth IRA is probably the way to go. You can continue to reevaluate the situation each year as you progress in your career and your life.

Just keep your eye open for any relevant changes, but get started sooner rather than later.

Just how important is this? Well, here’s a scenario of what could have happened if I had started investing just $1,000 per year in a Roth IRA when I first began working at age 15, according to this calculator and assuming a 7% rate of return.

AgeRoth IRA Balance

Now, $300,000 isn’t enough to retire on, for sure. But this is also with only saving $1,000 a year–a mere $83 and some change each month. That’s half as much as most people pay for cable or a cell phone plan these days! So once you decide to go Roth or go traditional, just go for it. The more you save, the better off you’ll be in the long run.

Article comments

Anonymous says:

I have a Roth IRA because I love that it’s a tax free investment vehicle because taxes are going to increase in the future and I plan to work for another 35 years before retirement.

Anonymous says:

Deciding whether to invest in a Roth or traditional IRA is fairly simple. If you expect your income to increase over the coming years go with the Roth otherwise go with the 401k or traditional IRA in that order. A Roth conversion depends on a number of factors so it is wise to use a calculator to see if it makes sense.

Anonymous says:

I’m young so I am investing in Roth vehicles now. As I get older and hopefully I move up in the marginal tax brackets I’ll start using traditional accounts and then take some from each in retirement to manage my tax rate. That’s my plan as I see it now but it is likely to change over the next 40 years…

Anonymous says:

I like the Roth. I figure you have more options when younger, and may not when old age sets in. And, I figure the tax rates will only increase, not decrease. I look at it like your younger self is giving a gift to your older self.

Anonymous says:

If only the older self was able to use the Roth IRA as a vehicle to give a gift to a child.

Anonymous says:

Since you are looking at predicting the future let me add a little known strategy that you may not be aware of. I’m retired, but because I had a 401(k) and an income level that exceeded ROTH IRA limits I didn’t start contributing to my ROTH until AFTER I retired – that’s right – after retirement – and without working. The IRS gives you the ability to “convert” tradition IRA assets to a ROTH IRA. All you have to do is pay the taxes. Being retired, my income level is in the 15% tax bracket and after deductions and exemptions there is headroom between my taxable income and the ceiling of the 15% bracket. By converting the saving to a ROTH I have to pay 15% tax on it, but – and it’s a big but – If I were to leave it alone, when I turned 70 and 1/2 the Required Minimum Distribution would push me well into the 25% tax bracket. Pay it now @ 15% or later @ 25%. It was an easy decision. One caveat: Although I can withdraw any of my contributions now without paying taxes the ROTH “account” must be 5 years old before the earnings are completely tax-free.

Luke Landes says:

That’s a clever strategy. I like it!

Anonymous says:

It wasn’t original thought, so I can’t take credit … I read about it in an article by a Professor from Baylor University and published by Kiplinger. But it’s working so I like it too!

Anonymous says:

I’m retired, too, so this is valuable. Back in the day, I figured I can manage my income when I’m retired. Since we don’t live a lavish lifestyle, the income we draw will usually be in the lower tax bracket. That, and my marginal tax rate at the time were enough to sway me to the traditional IRA, and not the Roth.

But this good information. Is there a limit on how much you can roll from trad to Roth? Or can you do it all in one fell swoop?

Anonymous says:

You can do it at one time but the taxes might be hard to swallow and you might lose the advantage of the lower tax bracket. What I do is convert just enough to bring me to the ceiling of my current tax bracket. Turbo-Tax usually comes out early enough that I do a trail return in December that gives me a good estimate of what I can convert. In the past two years we’ve managed to just move shares and pay the taxes from non-deferred accounts which increases the benefit of conversion. My estimate right now is that when (or if) I live long enough I’ll push my marginal tax rate increase out about 4 years past 70 and 1/2. Since I started this in 2008 that would equate to nearly $30,000 in tax avoidance.

Anonymous says:

I am hedging my bet and investing in both. It fits in my philosphy of multiple income streams.

Anonymous says:

Exactly! I have Roth and Traditional IRAs. I was thinking of converting my traditional and realized it was silly to pay the taxes on it. I asset allocate, not only with funds, but between the various types of investment accounts. You never know what the government might have in store for us in the future.

Anonymous says:

One additional point is that many employers do not offer Roth 401(k)’s. So, if you’re investing in both a 401(k) and an IRA, use one traditional and one Roth. Employer matches go in the traditional 401(k), which is good to keep in mind.

Anonymous says:

Couple points I’d add :
– Everyone gets a certain amount of tax free income via the standard deduction and exemption. So a married couple in their 60’s would have about $20k of tax free income. For this reason you should start with a traditional IRA to take advantage of that tax free income at retirement time. Unless you have other forms of taxable income in retirement then it makes sense to have a sizable amount in traditional IRAs to use the deduction/exemption.

– If you happen to currently have 0 tax liability and an effective 0% tax rate than the Roth is the nobrainer choice. Us the Roth to lock in the 0% tax today and get $0 tax in retirement.

Anonymous says:

Thanks I didn’t know that Traditional IRA’s had a tax benefit that phased out depending on income.

Anonymous says:

Since predicting the future is rather futile, I believe in a balanced approach, so I have both traditional and Roth IRAs. If forced by circumstances to choose between making a tax-deductible contribution to a traditional IRA or a contribution to a Roth, my personal preference is to take my tax benefit NOW when I’m certain of both the magnitude of the benefit and that I’ll get it, so I’d choose the tax-deductible traditional contribution.