Roth IRA vs 401k/Traditional IRA
Posted by Frugal on July 14th, 2006
The primary reason for putting money into 401K or traditional IRA account is for the current tax benefit. However, if the current tax benefit is small, it may not make a lot of sense to stuff money into your IRA account. Obviously, we don’t know what the future tax rates will be, but my best guess is that it will be higher, if not much higher than today’s tax rates & brackets. The reason is that the coming dues of social security & medicare services will simply drain the tax revenue base, and will require raising tax (and lowering benefits and probably print more money) to cover any shortfalls.
If you’re not paying much income tax, or your marginal tax bracket is not that high (below 20%), I would actually consider not saving in your pre-tax accounts, but instead saving those money in Roth IRA. A Roth IRA is an IRA that you pay tax now, but don’t pay tax later on the earnings. Comparing Roth IRA to individual IRA, it has a couple of benefits like no forced withdrawal, nor an age limit on the contribution.
While it may be extremely time-consuming to go over the 100+ pages of IRS Pub 590 document on traditional IRA & Roth IRA, you can use my tax calculator to figure out the contribution limit on your Roth IRA & traditional IRA accounts. The calculator may not contain all the necessary inputs, but for the most part, it suffices.
The decision over whether Roth IRA vs 401k/IRA is actually pretty simple. Excluding the factor of company match on 401k account, for investing in Roth IRA in respect to pre-tax dollars, you will be getting taxed now. And for 401k/traditional IRA accounts, you will be getting taxed (much) later. Assuming that the rate of return on investment is the same for both scenario, if the tax factors are exactly the same, then both decisions will come out equally. If you think tax rate may go up, or your retirement income may be quite high due to all the accumulated assets, then it might be better to just take some tax bite now instead of 30 or 40 years down the road.
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August 7th, 2006 at 12:06 pm
Tax Carnival #3: A virtual tax vacation…
Summer’s winding down. Kids are getting ready to go back to school or, in some places, already have returned to class. And if you’re like me, you feel like you never really got a break. Well, we’ve got the perfect end o’ summer remedy: Carnival of …
December 14th, 2006 at 2:11 pm
anyone here done a Qualified Retirement Plan Rollover like it says in this article, http://www.roth-ira-rules.com/ira-rollover-transfer.html
A Qualified Retirement Plan Rollover occurs when an individual takes personal possession and responsibility of his IRA assets and does NOT do an IRA Transfer within 60 days. Once the IRA assets are distributed, the plan administrator will withhold 20% of the amount for tax purposes and 80% of the assets will be distributed to the IRA account owner. This complication makes Qualified Retirement Plan Rollovers a less attractive choice.
how complicated did you find this task?
January 24th, 2007 at 9:26 am
Your site has been so very helpful. Quick question about 401k v. Roth.
I am 27 yrs old and have about $5000 a yr to contribute to savings. My company does not match our 401k plan but instead contributes an annual 3% of our yearly salary no matter how much we contribute. I am currently contributing to both our 401k plan and a Roth IRA. Would my money best serve me in the 401k or should I max out my Roth instead and contribute the remaining $1000 to my 401k? Any help or suggestions would be great. Thanks!
January 25th, 2007 at 12:24 am
If your current marginal bracket (including state tax) is more than 33%, I would put it into 401K. Just my two cents. This is based on the assumption that you can have a lower future tax rate than 33%.
I assume that if you’re single, your tax bracket can potentially be higher.
February 9th, 2007 at 2:26 pm
I am 38,single, own a home that i may sell in a couple of yrs. Worth 350,000 owe 320,000. have no other debt. Just changed jobs and my 2006 AGI is 93500. It will most likely be over the contribution limit for a Roth next yr. My job has a 403b without match. and i contribute the max… they have a cash balance retirement that is based upon my age and tenure here. That will start at 6% of my income and increase to 12 by the time i retire base upon the 30yr bond rate.
Is it to my advantage at all to throw 4000 into a Roth now… Possibly never being able to contribute again? Or not… I hesitate to contribute more to my house as I may sell soon. Any help would be appreciated.
February 16th, 2007 at 4:21 am
Please try not to ask me personal financial advice, because I’m not qualified to reply, and I’m afraid that you don’t do your own due diligence.
Having said that, as I have probably said previously, if your marginal tax bracket (Fed + state) is more than 35% to 40%, I will advise you to contribute into a deductible retirement account.
Best regards.
April 29th, 2007 at 7:27 am
Two points in favor of the roth IRA you didn’t address. One if your maxing out your IRA with either traditional or Roth. The better choice is Roth. Although not recommended lets look at it like this. You put your pre tax 4k in to a traditional IRA today. I put my 4k roth IRA today as well. Both of us a tomorrow (for whatever reason) from now take it out early. Setting aside penalties as I believe them to be the same for both (so thats a wash) I have my 4k relatively intact you on the other hand have to pay taxes. I’m not saying this just in case you withdrawal early. The benefit is there also if you follow all the rules until retirement because essentially if you give to the traditional IRA you aren’t giving as much money as you are with the Roth IRA (in the case of maximizing to contribution limits). So if your going to contribute the maximum either way I believe the Roth is the way to go.
The second point involves some speculation (albeit not a lot)about where tax rates will be when we retire. I don’t think I’m going out on a limb here given our govt’s unwillingness to control spending. in paticular the entitlements area (specifically social security). There is essentially only 3 things they can do to keep this viable 1 raise the age limit (which means we have to fend for ourselves for a longer period)2. Cut benefits or 3. Increase taxes 4. A combination of the previous 3 which will over the long haul be the most likely. Any of these scenerio’s though just bolster Frugal’s arguement about investing “NOW” don’t wait. There is a whole host of examples that our gov’t is incapable of taking care of us when times get tough Katrina is the most recent of those. Those who were prepared avoided being directly hit by the disaster those who weren’t didn’t. Have a plan B.
There is one case I can think of where the traditional IRA might be of greater benefit. I saw this happen this year to a friend of mine. He needed to get his taxable income down in order to be qualify for numerous deductions. If he would have contributed to the traditional IRA he would have met that threshold consiquently he left 17k in deductions off his return. This circumstance is at the higher level of incomes so some forsight is required.
May 1st, 2007 at 7:15 am
I hate to say it Brian but you are wrong. It is simply a timing difference. So the $4000 in the roth ira has already been taxed, but the traditional IRA will be taxed afterwards.Therefore the traditonal IRA allows for maximum growth. (All things being equal,and the tax rates didn’t change, this would be a better one. However, everyone anticipates an increase in taxes over the next 30 years, but no one knows how much. It is a roll of the dice. Basically, is the tax rate going to go up so much that it will be better to be taxed annually rather than be taxed thirty years for now, even with the growth factor. Also, there is an option to roll a traditional IRA into a roth IRA. This allows for maximum growth in the traditional IRA until tax rates begin to increase, and then you just roll it into a roth ira before the taxes get too high.
March 28th, 2008 at 11:23 pm
That is a very informative article. If a person is expected to be in a higher tax bracket upon retirement, a Roth IRA is the best choice because you pay taxes now, and get over with it. You will be able to build your retirement savings in 20-40 years and not owe a single dime to Uncle Sam!
I also like your point about who knows where future tax rates will be? America has trillions of debt (especially with Bush spending so much on the war on Iraq and racking up lots of debt). How will future governments & citizens be able to pay for this debt? I read somewhere that the average American debt is about $8000 per person, it will get a lot higher than that. The government will obviously raise future tax rates to be able to pay for this debt, thus a Roth IRA is the best choice. Go here http://www.definerothira.com to learn more about my IRA investing theories.
October 6th, 2008 at 7:58 am
One big factor for me is fund choice. My 401k has poor fund choices, so max my Roth IRA before putting anything in my 401k. My Roth so far this year is beating my 401k by 6% on average.
October 22nd, 2008 at 3:59 pm
Brian is not wrong; the difference is not simply when will you pay the tax. The difference is actually having money grow that is tax-exempt or that is tax-deferred. With a traditional IRA you don’t pay tax now. Every year’s earnings also grows tax deferred. Then when you withdrawal at retirement, both the contributions and the earnings will be taxed at tax rate you are in at retirement. So, if you contribute $5,000 for 30 years, you will contribute $150,00. If your earnings on those contributions amount to $600,000, you have a total next egg of $750,000. If you take out 5% a year to live on, which is $37,500, along with your social security of $2,000 a month ($24,000 yr) you get combined income of $61,500. Only a max 85% ($20,400) of SS income is taxable, so $20,400 plus $37,500 or $57,900. Lets say you dont have a mortgage and your deduction are less than the standard deduction of $10,700 (MFJ); after subtracting the standard deduction and exemptions ($6,800 MFJ) you get $40,400 of taxable income each year. If the tax rates are similar to what they are now you would pay $5,821 in taxes. You would be in the 15% tax bracket (assuming you are in 25% current bracket), which may be lower than your current bracket, but you are paying taxes on a lot more income!
Under the Roth IRA, you would have paid ($5,000 X 25%) $1,250 each year in extra taxes. However, the entire earnings would come out tax free in retirement. So, you income would be same as under the traditional IRA, but the taxable income woudl be much less. Of the $24,000 of SS income you received, only 50% would be taxable. So, your taxable income would be $12,000 which does not include any of your Roth IRA distributions. Then you would subtract the standard deduction of $10,700 to get to $1,300. From that, take away your standard exemption of $6,800 and you have $0 taxable income. You pay no taxes in retirement!
Comparison: Roth- you pay $1,250 of taxes each year for 30 years and never again. Your total tax paid is $37,500.
Traditional- No taxes for 30 years; then pay $5,821 in taxes from age 60 until you die. If you live until 85, then ($5,821 X 25) total tax is $145,525. Then if your spouse survives you by 5 years they will pay similar taxes on their distribution of your IRA. Then when your spouse dies, the children or whoever you decided get the IRA and pays taxes on the distributions.
So, $145,525 in taxes (plus taxes paid by surviving spouse and surviving child) or $37,500 in taxes. Which would you rather pay?
Personally, I would fun my 401K up to my employers maximum match. Then I would max out the Roth IRA. If I still have more money to contribute, then I would go back to maxing out my 401K.
Also, a Roth IRA is a good tax planning tool to provide your descendents with a tax free annuity. When you die, the IRA can go to your spouse, who takes over as you, meaning they don’t need to take distributions and can continue to only withdrawal the yearly earnings (5%). She your spouse dies, then your child gets the IRA. They then take distributions according to their expected remaining life based on actuary tables. Again the money comes out free of taxes!
October 30th, 2008 at 10:59 am
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