Traditional vs Roth IRAs – How to Decide

In our last post, we reviewed the potential benefits of Roth IRA conversions in a down market. To follow-up, we wanted to walk through how you determine whether to invest your money within a Traditional IRA or Roth IRA in the first place.

As a quick overview, Traditional IRA contributions are made before taxes, and withdrawals are taxable as ordinary income. Roth IRA contributions are made after taxes, but withdrawals are tax-free. 

Choosing a Traditional IRA sounds great because you don’t have to pay any taxes for a long time, but Roth IRA’s allow you to take the money out tax free in the future. Each has unique benefits, making the decision a tough one for many investors. 

If only there was a way to determine which choice is expected to maximize your wealth… Well luckily there is! 

Determining whether to invest in a Roth vs Traditional IRA largely boils down to considering tax rates. Essentially, you are comparing your current tax rate to your expected future tax rate. Knowing exactly what tax rates will be in the future is not possible (if you can predict the future, please see us as we would like to make you part of our team), but you can try to estimate future tax liabilities in order to make an educated decision.

When estimating future taxes, it is generally best to keep it simple. For example, assume there are two people. The first person is early in their career and currently makes $30,000 per year. The second person is nearing retirement and is making $100,000 per year. If both people expect to live off of $70,000 per year during retirement, we can assume the first person is currently in a lower tax bracket than they will be in during retirement and the second person is currently in a higher tax bracket than they will be in during retirement. 

If you are currently in a lower tax bracket than you expect to be in the future, like the first person, you should contribute to a Roth IRA. If you are currently in a higher tax bracket than expected in the future, like the second person, you should choose the Traditional IRA. If you expect your tax rate to be the same, then it does not matter whether you choose the Roth or Traditional IRA as the outcome will result in the same amount.

To put some numbers to this, let’s say you are in the 15% tax bracket and have $5,000 to put in a Traditional IRA (the equivalent would be $4,250 to put in a Roth IRA after paying 15% taxes on the $5,000). If you assume the money grows at 8% per year for 10 years, the Traditional IRA will have a balance of $10,794.62 and the Roth IRA will have a balance of $9,175.43. 

So obviously the Traditional IRA is the smartest choice, right? Well not quite.

This is where the taxes come into play – you still have to pay taxes when you withdraw from the Traditional IRA, but the Roth IRA money can be withdrawn tax free. So the value of the Roth IRA is actually $9,175.43 of spendable dollars. If you expect to pay 10% in taxes in the future (less than your current 15%), when you take money from the Traditional IRA you will get $9,715.16 which is more than the Roth IRA. If you expect to pay 15% in taxes (same as your current), you would get $9,175.43 which is the same as the Roth IRA. If you expect to pay 20% in taxes (more than your current), you would get $8,635.70 which is less than the Roth IRA.

This is a simplified example, but the important takeaway is this: 

• Current Tax Rate > Future Expected Tax Rate = Use Traditional IRA
• Current Tax Rate = Future Expected Tax Rate = Indifferent 
• Current Tax Rate < Future Expected Tax Rate = Use Roth IRA 

Another important, yet relatively simple assumption you can make is comparing current tax rates to historic tax rates. If current tax rates are historically low (like they currently are today), a Roth IRA might make more sense as we would expect taxes to increase at some point in the future back to “normal” levels. However, if current tax rates are historically high (like they were in the 1950’s), a Traditional IRA might make more sense as we would expect taxes to eventually fall in the future. Just like anything else, taxes tend to shift in cycles and regimes. 

While no one can predict with exact certainty what tax rates are going to be in the future, we can plan for expected changes in the future. For example, in December of 2017 President Donald Trump passed what is known as the “Tax Cuts and Jobs Act.” This act did several things for individual taxpayers, including but not limited to:

• Reducing marginal tax rates
• Increasing the standard deduction
• Reducing and eliminating some itemized deductions
• Increasing the child tax credit
• Eliminating personal and dependent exemptions

The most important change to note here is the reduction of marginal tax rates. But, there’s a caveat. Unless congress makes changes between now and December 31st, 2025, the act is set to expire on this date. What does this mean? Well, in reference to the change in marginal tax rates, they will increase. While there’s a lot of time between now and the sunset date, that doesn’t mean this can’t create an opportunity for individuals from a planning perspective. 

Though the decision largely boils down to tax rates, other factors beyond just taxes come into play too such as income limits, early withdrawals, and RMDs. This is why it is  important to work with your CPA and financial planner to determine which account type is the best fit for you and your current situation.

Derek and Ben

Co-Founders and Owners of Aspire Wealth