IRA versus Roth IRA

Deciding factors: if the contribution is deductible, tax bracket in retirement versus tax bracket today, income levels today, current age, and availability of  retirement plan at work.

If the question is whether you should invest in an IRA account (including traditional and Roth), then the answer is YES (capital bold yes)*. If the question is whether you should contribute to a traditional IRA or a Roth IRA, then the answer is ‘it depends’.

It primarily depends on several factors. Two of these factors are the most important: whether the contributions are taxable in the current taxable year, and whether you expect your tax rate to be higher or lower (as compared to the current rate) in retirement.

The basic idea of an IRA account (traditional and Roth) is 'Money is taxed by the IRS only once' - either you get taxed now OR you get taxed when you withdraw the money in retirement.

If you get taxed now, you are making a Roth contribution (that goes to the Roth IRA account). If you choose not to be taxed now, you are contributing to a traditional IRA account (from which the withdrawals are taxed).

Traditional IRA accounts are what is called a tax deferred account. Roth IRA accounts are what is called tax exempt accounts. So in traditional IRA, you pay taxes at the end while in Roth IRA, you pay taxes upfront (today).

Basic rules about IRA accounts

  1. You need to have earned income in order to be able to contribute to an IRA account.
  2. There are no income limits for contribution to Traditional IRA – anyone can contribute irrespective of their income levels (up to the limit).
  3. Traditional IRA contributions tax-deduction phases out for higher income levels.
  4. Roth IRA contributions are never deductible. And Roth IRA contributions phase out with higher income levels.
  5. Traditional IRA withdrawals are taxed at ordinary income (except the non-deductible contributions portion).

Traditional IRA or Roth IRA?

Use the following flow chart to understand whether you are better off contributing to a traditional IRA or a Roth IRA:

Download IRA versus Roth IRA _ Decision Tree

Conclusion

The following table summarizes what the above flow chart explained in detail:

IRA versus Roth IRA _ Decision Table

IRA versus Roth IRA _ Decision Table

MAGI stands for ‘Modified Adjusted Gross Income’ – In most cases, it is very close to AGI (Annual Gross Income), actually slightly higher.

*Caveat 1 – You can afford to keep the money invested till retirement.

*Caveat 2 – The only investment vehicle that comes close to an IRA (and can even be better) is a 401k contribution. I will compare 401k and IRA contributions some other time but for the sake of this article – let us assume that you have maxed your 401k contribution ($18,000 for 2015). And now you are wondering whether you should invest in an IRA – the answer is a no-brainer YES.

OneMoreDime Special: Ordinarily the IRS imposes income limits on those who can contribute to the Roth IRA (for example, those single filers in 2015 who make more than $131,000 are not eligible). But with the “Back door entry to the Roth IRA“, anyone can contribute.

OneMoreDime Special: If you are under the age of 50, the total you can contribute (across your traditional IRA and Roth IRA) is $5,500. If you are unable or unwilling to make a reasonable guess your tax rate at retirement, consider splitting the contributing – $2,750 in a traditional IRA and $2,750 in a Roth IRA.

10 thoughts on “IRA versus Roth IRA

  1. This topic has been beaten to death, but I really like your take. And I love decision trees.

    It will come handy in a few weeks

    • Lol yes, you are right, this topic has been beaten to death. In fact, I was reluctant to write this post but a friend challenged me to find a ‘definitive guide to make the selection’.

      He said – there are all kinds of articles on the internet – most of them do not cover all the aspects, the ones that do are just so much English text to read and still leave all the ‘decisioning’ to the user. Hence – the decision tree (flow chart)

  2. Yes, I also have to say Im glad you did decide to write about it. Every page I would find on this topic seemed just to be a regurgitation of another post’s info. None of what it really offered an actionable quideline and steps in a needed decision making process like this has done. I already forwarded this to several friends and fam. for a peek. 🙂

  3. Deli – great and thank you.

    Thank you that you forwarded it to several friends and family. The more readers we have on this blog – the more driven I will be to write more (and in addition the quality of discussions via comments will also be better).

  4. Very nice and informative, Bobby.

    I have a question. My company offers;

    Pre-tax 401(k), Roth 401(k) and After-tax 401(k).

    My currently max out Pre-Tax and After-tax 401(k) accounts. However, I’m researching these options and could use a bit of your advice:

    1. Max out Roth and After-tax 401 (k). That is, I won’t be contributing to Pre-tax 401(k) at all.
    2. Contribute to Pre-tax an amount equal to get full company match and the rest into After-tax 401(k)
    3. Stick to my current plan. Max out Pre-tax and After-tax 401(k)s.

    Your thoughts on the options? I company offers in-service conversion of After-tax 401(k) to Roth.

    Also, I heard (haven’t confirmed) that you can withdraw the principal (not the gains) from After-tax 401(k) at any time without having to pay a penalty. Is this true? Is this true if it’s converted to Roth (via in-service conversion)?

    Thank you!

    Joe

    • Joe,

      Maxing out pre-tax dollars is a good idea because these dollars are tax-deductible. Unless you are expecting your income tax bracket to be higher in retirement (unlikely for most), making pre-tax contributions is a good idea. So you pay taxes on contributions as well as earnings on withdrawal.

      On the other hand, post-tax deductions make sense either when you will be in a higher tax bracket later OR you have 30-40 years of compounding before you withdraw (in which case earnings withdrawal being tax free makes a big difference).

      About the second point – there will be a penalty if anything is withdrawn before certain conditions are met (mostly the 59 1/2 age).

  5. Yes, the guide is helpful. Thank you for posting. Some financial and tax discussions get me confused so please excuse me if my question is too basic…
    A financial advisor made recommendations on IRAs to me a while back when I left an industry job for academia. I now have two Roth IRAs – contributory and conversion. I have not made contributions to them in about 10 years since I was contributing to a 403(b) (the 401k equivalent for non-profits). Now that I have transitioned to self-employment (for now) with a reduction in salary, I want to make contributions to my IRAs. After reading this, I’m not sure whether to contribute to the contributory Roth or start a traditional IRA. Any suggestions would be very much appreciated.

    • Joey – I know a lot of literature (and practitioners) talk about Contributory accounts and that can be confusing.

      If we talk about IRA accounts – there is a traditional IRA and there is a Roth IRA account. PERIOD.

      (A lot of people will differentiate between a Roth IRA and contributory Roth IRA based on how it is funded – but that is immaterial). There is a traditional IRA and there is a Roth IRA.

      Now read my post again and hopefully it will be easy to decide which one to contribute. For example – traditional IRA contributions are tax deductible up to a certain income level while Roth IRA deductions are never tax deductible.

      But direct Roth IRA contributions are not allowed over a certain income limit (hence people use back door entry to the Roth IRA).

Leave a Reply

Your email address will not be published. Required fields are marked *