Should You Choose A Traditional IRA or Roth IRA?

Should you choose a Traditional IRA or a Roth IRA?

How would you like to retire early? Or keep Uncle Sam’s fat fingers off your hard earned money? Besides employer retirement plans a self-directed IRA is one of the best investment options available. And if you don’t have an employer plan, it may be one of the few options you have to save for your retirement.

But should you choose a Traditional IRA or a Roth IRA?

If you have the same tax rate now vs. in retirement, the taxes you pay will be almost identical. What that means is it would make no difference if you did a Traditional IRA vs. a Roth IRA. You can see for yourself by using this Roth vs. Traditional IRA calculator.

Note: The calculator has a slight variation, but it’s pretty close.

The problem is, you likely have no idea what tax bracket you’ll be in between age 59 1/2 until you die. That’s because the tax code changes every year, and tax brackets have changed many times over the past decades. If you retire at age 60 and live until age 90, you can expect your tax rate to change unless you primarily rely on the government to fund your retirement.

But if you’re an avid listener of my show and follow my advice, you’ll have accumulated maximum wealth for your situation and income. In which case you could end up paying more in taxes (a good problem to have because it means you’ve got more money).

Differences between a Traditional IRA and Roth IRA

Here is a quick chart with the differences between a traditional IRA and a Roth IRA.

Traditional IRARoth IRA
Is there an income limit to contribute?No, but there is to get a tax deductionYes, there is a phase-out period depending on your income
Are contributions deductible?Yes, up to an income limitNo
How much money can I contribute?$5,500$5,500
Are there catch-up contributions?Yes, $1,000 if you are 50 or olderYes, $1,000 if you are 50 or older
Are there early withdrawal penalties?Yes, 10% before age 59 1/2Yes, 10% before age 59 1/2
Can I take early distributions without penalties?Yes, for qualified expensesYes, for your contributions and for qualified expenses
Is there a cut-off age for contributions?Yes, age 70 1/2No
Are there required minimum distributions (RMDs)?Yes, at age 70 1/2No
What tax rate will I pay?Your ordinary income tax rate when you withdraw the moneyYour income tax rate in the year you make the contribution

Which IRA Makes Me More Money?

First make sure you’re getting any free money from an employer contribution plan (401(k), 457(b), 403(b), etc.) By free money, I mean any employer match.

If you have additional money to invest the next best option is a Health Savings Account (HSA) if you have access to one. I’ve written an extensive guide on why an HSA is the best investment option available.

After that the question becomes:

Do you want more money?

All comparisons aside from the chart, at the top of most people’s lists, is which investment choice gets me the most money.

Knowing your current tax rate and what your expected tax rate in retirement is critical in avoiding taxes and deciding on what type of retirement plan contribution to make.  In general:

  • If you think you will have a higher tax rate in retirement, you’ll likely have more money if you put money into a Roth IRA
  • If you think your tax rate in retirement will be lower than what it is now, go with a Traditional IRA
  • If you’re approaching retirement age and your certain you will be in the same tax bracket, I’d go with a Roth IRA

Does My Age Make A Difference?

How old you are can help you decide between a Traditional and Roth IRA. If you’re in your 20’s and 30’s and in a lower tax bracket, you don’t get as big of a tax deduction from contributing to a Traditional IRA. The Roth makes more sense because you could be in a higher tax bracket in retirement.

However, someone in their higher earning years (typically 40’s, 50’s, and 60’s) can benefit from getting the deduction for a Traditional IRA contribution. In retirement, you’ll likely be in a lower tax bracket.

Is a Traditional IRA or Roth IRA Better for Early Retirement?

What if you want to retire before age 59 1/2? Many people in the Financially Independent, Retire Early (FIRE) community prefer the flexibility of the Roth IRA. Why? You can pull out your contributions at any time before age 59 1/2 without penalty.

For example, say you’re 30 years old and want to retire at age 40:

  • You contribute $5,500/year to a Roth IRA for ten years ($55,000 in contributions)
  • The account value after ten years is $100,000
  • You can withdraw the $55,000 in contributions anytime before age 59 1/2 penalty free

For more information please check out the IRS website. And it’s always a good idea to sit down with a financial advisor and tax planner to avoid as much tax as possible.

Planning ahead and can keep more money in your pocket and out of the governments.