In Defense of the Traditional IRA

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Roth IRAs are tax-free.  Traditional IRAs are simply tax-deferred.  Surely tax-free is better, right?  And surely, therefore, a Roth IRA is the best way to invest for retirement, right?

Well, not exactly.  I’d argue that the typical terminology is a bit misleading.  Rather than thinking about “tax-free” as compared to “tax-deferred”, I’d suggest thinking about it this way:

• Roth IRA = “taxed now”
• Traditional IRA = “taxed later.”

With a Roth IRA, you are taxed. You’re taxed before you even get to put money into the account.  (Then, when it comes out, it’s tax-free as long as you jump through the appropriate hoops.)  With a traditional IRA, you get to contribute money before being taxed on it.  (Then, when it comes out, it’s taxable.)

So which is better: being taxed now or taxed later? The answer is that it depends on how you expect your tax rate in retirement to compare to your current tax rate.

• If you expect a higher tax bracket in retirement, a Roth is likely better.
• If you expect a lower tax bracket in retirement, a traditional IRA is likely better.
• If you have absolutely no clue, it probably makes sense to tax diversify (that is, put some money in each type of IRA).

Estimating Your Future Tax Rate

Many people argue in favor of the Roth because they assume they’ll be in a higher tax bracket in retirement than they’re in right now.  But what if, rather than purely guessing, we actually took a shot at calculating how much money it would take to put you into a given tax bracket in retirement?

Fortunately, fellow blogger Joe Taxpayer has done exactly that.

The answer: If your IRA is your only source of income in retirement, you need a lot of money before you even hit the 25% tax bracket.  Specifically, based on 2010 tax brackets (and a 4% withdrawal rate), you’d need:

• $467,500 in tax-deferred accounts before anything would be taxable,
• $886,250 in tax-deferred accounts before moving beyond the 10% tax bracket, and
• $2,167,500 in tax-deferred accounts before moving beyond the 15% tax bracket.

In addition, because tax brackets are usually adjusted upward in an attempt to keep up with inflation, these numbers will likely be significantly higher if you’re retiring in the distant future.

Dealing with Uncertainty

On the other hand, many people will (correctly) point out that tax rates do change over time, and it’s possible that what is now the 15% tax bracket could quite possibly be, say, a 20% tax bracket a few years down the road.

Most people suggest that such legislative uncertainty is a reason to go for a Roth — the idea being that, since it’s likely tax rates will be higher in the future, it’s best to be able to count on tax-free withdrawals.

However, a similar argument can be made against the Roth. While the tax code is currently set up so that withdrawals are tax-free, there’s no reason that this couldn’t change.  All it would take is the passing of a new law — exactly the same thing that’s required to change tax rates.

And lest you think that this sort of thing could never happen, let me point out that it has happened.  When Social Security was created, it was entirely tax-free.  Now, depending on your income, up to 85% of social security benefits can be taxable.

When a Roth Makes Sense

In short, unless you’re:

1. In a very low tax bracket right now (say, 0% or 10%), or
2. Planning to have some source of retirement income other than investments,

…you may want to consider sticking with a traditional IRA — or a tax-deferred plan at work, like a 401(k) — for the bulk of your retirement savings.

About the author: Mike Piper writes at Oblivious Investor where he provides plain-English explanations of topics like Roth IRA withdrawal rules and 2011 tax bracket changes.

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