Ok, so we don’t have to be as dramatic as Tony Soprano writing off a turncoat family member, i.e. a rat, but ever since the introduction of the ROTH IRA the Traditional IRA has not looked quite as good. In fact, for many investors, the Traditional IRA is dead to them.
The debate over which is better, Roth or Traditional IRA, comes down to two things: flexibility and taxes. Especially taxes. A ROTH account is the best way to convert taxable gains and income to tax free gains and income.
A traditional IRA is a solid pre-tax instrument, because the annual one time tax deduction results in the IRA being funded with pre-tax dollars. That’s a big thing for those who feel they need the tax deduction in the current tax year. Sure, this one time, upfront tax break ensures that your current tax bill will be lower, but it also ensures there will be a large, looming tax bill waiting for you in the future when you take your money out.
So your decades of investment gains, which would be taxed at favorable capital gains rates outside of a qualified retirement account like a traditional IRA, will be taxed at the more confiscatory ordinary income rates when drawn in retirement. By using the IRA and taking a small current tax break, you may have unwittingly converted what could have been a small tax now for a larger one in the future.
A Roth IRA, on the other hand, allows no upfront tax deduction in the contribution year like the traditional IRA, but instead it offers you something much more powerful: the ability to convert taxable income into tax free assets and income! This is huge. You will fund your ROTH with after tax money for the tax year in which you make a contribution, and since the income you made your contribution with was already taxed in the year it was earned, your tax bill has been stamped paid, and your money can grow tax-free for as long as you own it.
Congratulations! You cheated the tax man (legally, of course).
The ROTH IRA has income limits for eligibility, which are high enough to make the ROTH accessible to most of us, and has far fewer restrictions than a pre-tax Traditional IRA.
…the debate over which is better, Roth or Traditional IRA comes down to…taxes…
While everyone’s income and tax situation is different, most will do well to trade the allure of a one time tax deduction for a lifetime tax-free machine!
To recap, the bottom line trade off is this: a one time, one year deduction vs. a lifetime of tax-free growth and income. Is there even a choice?
Your capital gains will not be taxed as ordinary income at much higher rates as with an IRA distribution. In fact they will not be taxed at all. Add to that powerful benefit, a ROTH offers more planning flexibility and absolutely no required minimum distributions.
This is not to say the Traditional IRA is without merit. If you leave your employer and are rolling over a traditional 401(k) you will need to roll it into a Traditional IRA, since both are pre-tax vehicles. It is likely that if you have been saving for retirement for a long while, so you will end up having both ROTH and Traditional accounts.
…the best way to convert taxable gains and income to tax free…
ROTH IRAs are more flexible and far less restrictive than traditional IRAs. The ROTH does not require you to start withdrawing by age 70½, the dreaded RMD, required minimum distribution. Whether you need the income or not, IRA rules say that you must begin scheduled annual distributions after you are 70½, and yes, they are taxed.
Whether you need the income or not, IRA rules say that you must begin scheduled annual distributions after you are 70½, and yes, they are taxed.
If you withdraw the account’s earnings anytime after reaching age 59½ (assuming the account is at least five years old), the earnings are tax free. These tax-free withdrawals are one of the biggest benefits of a Roth IRA compared to a 401(k) retirement plan.
…your withdrawals will always be tax free…
Again, ROTH does not demand distributions, and as an estate planning tool, your beneficiaries won’t be taxed when your account goes to them. Further, you can have or add to a ROTH at any age, but there are income limits and contributions are based on earned income.
A Traditional IRA is tax-deferred, but a Roth IRA is tax free, so that makes it a more efficient and more powerful tax planning device than a Traditional IRA, or a 401(k) for that matter. If you follow the IRS rules, your withdrawals will always be tax free.
Here is an exaggerated example:
I buy 1000 shares of stock XYZ at $10. It grows to $1000 a share! My $10,000 investment grew to $1 million.
If this investment is not in a qualified retirement plan, the gain would be taxed at the then current capital gains rate when I sell. The top long term capital gains rate for the majority of taxpayers is currently 20%. If I sold my entire position, I would have a $990,000 capital gain, on which I would owe Uncle Sammy $198,000.
In a Traditional IRA, my $990,000 gain would not qualify for the more favorable long term capital gains rate, it would be taxed as ordinary income at the top bracket of 39.6% currently.
Assuming I am over 59 ½, an easy assumption since I am, I will not be triggering any early withdrawal penalties, so Uncle Sam would expect a check from me in the amount of $392,040.
But it’s a different story if I have my investment sheltered in a ROTH. The tax bill on my $990,000 gain? Nothing. Nada. Zero.
Now, I did disclaim this was an exaggerated example, both in the monster sized gains (but it can happen!) and the foolish handling and timing of our distributions (sadly, that happens, too!).
…you will KEEP more…
Please understand that there is no one-size-fits-all investment or strategy, and we do not intend to imply that there is. Income requirements, overall tax situation, age and time horizons all play a part in every financial decision. But for most people, the ROTH has become the preferred way to shelter their retirement assets, protect their future growth and minimize taxes. So in most cases, a Roth IRA is far superior to a Traditional IRA, because you will KEEP more. Period.
And isn’t keeping it the whole point of making it in the first place?
As always, consult a Certified Financial Planner professional to help guide these most important life decisions.