And when it may not be better after all…
It was 1993 and I was a post-doctoral fellow at Texas Tech University. I had just had a conversation about saving for retirement with a grad student from the University of California, San Diego. Although he was still in his twenties, he was already setting aside money and investing it for his retirement. I guess I should be doing the same, I thought.
A visit to the Texas Tech library introduced me to the Morningstar Directory of Mutual Funds. After spending three weeks’ worth of spare time learning how to use the directory to pick funds, I signed up for my first IRA and sent a modest contribution of $1000. Making just over $31,000 with a family of four, it was hard to spare more than that.
Back then, the only IRA option I had was the traditional plan, established by the Employee Retirement Income Security Act of 1974 (ERISA). It was years later that the Roth IRA was established by the Taxpayer Relief Act of 1997.
Had the Roth IRA existed in 1993, I’d have chosen that type of account. Now that both options are available, you would most likely be better served by a Roth IRA than a traditional one. Below I explain why, and caveat with the few situations where that might not be so for you.
First Some Stats
If stats make your eyes glaze over, feel free to skip this section. It just points out the importance of retirement plans in general and IRAs in particular.
The Good Old Days of Pensions Are Gone
Decades ago, almost all American workers had a pension, a defined benefit plan. As of July 2019 according to PensionRights.org, the numbers are far lower. Just 22% of full- and part-time American workers, and 13% of private-sector workers participate in a pension plan.
You see, over time, corporate America realized they’d much rather let you, the worker, shoulder the market risk of investing for retirement. After all, if they invest for you and things go badly, they’d still be on the hook for your retirement.
Workplace Retirement Plans Let You Shoulder the Market Risk
Enter the 401(k) plan (plus its 403(b) “brother” for employees of public schools and certain tax-exempt organizations, and the less well known “cousin,” the 457 deferred compensation plan for state and local governments, hospitals, educational organizations, charitable organizations or foundations, and trade associations).
All these so-called defined contribution plans make no promise as to how much money you’ll have for retirement. That depends on what investments you choose, and how well those happen to perform over the years and decades until you retire.
Makes sense doesn’t it? After all, you’re so much more knowledgeable about investing and market risk than any financial pro your employer could hire or contract, right? Not! To paraphrase the Evil HR Manager from the Dilbert cartoon, they do it “Because we can!”
Many American Workers Don’t Even Have Access to Any Workplace Plans
Worse, according to the Pew Charitable Trusts, as of 2017, 35% of workers had no access to a workplace retirement plan at all. And Millennials specifically? An alarming 68% have no accessible workplace retirement plan! This means that millions of American workers don’t even have the “luxury” of taking investment risk away from their employers by saving through a workplace retirement plan.
All this makes the IRA even more important to your retired self’s financial health. According to a 2019 report from the IRS, as of the 2016 tax year, 47 million American taxpayers had traditional IRAs with an average balance of $146k; and 20 million had a Roth IRA with an average balance of $35k (some taxpayers have both types of accounts).
Roth vs. Traditional IRAs: Comparing the Features
Here Is How the two IRA Types Are the Same
- Contribution Limit: Your contribution is limited for both types of IRA by the lower of an IRS-imposed limits (for tax year 2019, $6000 with a $1000 catch-up amount if you’re 50 or older) and your earned income for the year. However, note that the Roth IRA has an additional limit (see below).
- Contribution Deadline: You can send your contributions to both types of plan until “Tax Day” of the following year.
Here Are the Many More Aspects where the Two Differ
The Roth IRA has no age limit for contributions, while contributions to a traditional IRA can only be made until you reach age 70½.
Income-Based Contribution Limit:
While there’s no income-based limitation on your ability to contribute to your traditional IRA, there is such a limit for the Roth IRA. Specifically, if you’re married and filing jointly, your ability to contribute to a Roth IRA phases out for tax year 2019 if your Modified Adjusted Gross Incomes (MAGI) is between $193k and $203k ($122k to $137k for single filers and heads of household; and $0 to $10k for married filing separately who lived with their spouse). If your MAGI is higher than those ranges, you cannot contribute to a Roth IRA (though you can make a “backdoor” contribution by contributing to a traditional IRA and converting that to a Roth IRA – a process that fraught with many caveats and a potentially hefty tax liability).
Tax Deduction in the Year of the Contribution:
Contributions to a Roth IRA cannot be deducted from your taxable income. Contributions to a traditional plan may be partially or fully deductible, depending on whether you or your spouse are covered by a retirement plan at work, and on your MAGI. Generally, if neither you nor your spouse, if any, are covered by a workplace retirement plan, your contribution (up to the above-mentioned IRS limits) is fully deductible against this year’s taxes.
- Withdrawals from Roth IRAs of amounts contributed to the plan are always tax- and penalty-free. Withdrawals of earnings are also tax- and penalty-free if you’re at least 59½ years old and the first contribution was made to the account at least five years earlier.
- Roth IRA withdrawals of earnings that don’t meet the above requirements on your age and the age of the account may avoid a 10% federal penalty and all taxes if you’re completely and permanently disabled, up to $10k (lifetime limit) withdrawn for a first-time home purchase, withdrawals made to your beneficiary or estate.
- Generally, any earnings or contributions to a traditional IRA that were previously deducted are subject to income tax in the year they’re taken. Withdrawals made prior to age 59½ are generally also subject to a 10% federal penalty, with some exceptions (see below).
- Traditional IRA withdrawals are subject to a 10% federal penalty if you’re younger than 59½, unless you’re totally and permanently disabled, the withdrawal is made to your beneficiary or estate, or to a reservist ordered or called to active duty after 9/11/2001 for more than 179 days, up to $10k (lifetime limit) withdrawn for a first-time home purchase, made to cover post-secondary education expenses, for certain unreimbursed medical expenses, to cover an IRS levy on the IRA, for health insurance premiums once you’ve received unemployment compensation for 12 consecutive weeks, or if you take substantially equal periodic payments under IRS guidelines.
Required Minimum Distributions (RMDs):
There are no RMDs for Roth IRAs during your lifetime. Traditional IRAs are subject to RMDs, so you must start withdrawing (and paying taxes on such withdrawals) by April 1 of the year following when you turn 70½, and by December 31 of each subsequent year. The RMD amount is determined by the IRS and is intended to approximately deplete the IRA by your death. Failure to withdraw your RMD can subject you to confiscatory penalties of 50%(!) of the amount you should have withdrawn and didn’t. The IRS may waive this penalty if your under-withdrawal was made due to a “reasonable error” and you file the proper paperwork.
Why You Should Almost Certainly Prefer the Roth IRA
Tax Break Timing
The main difference between the two types of IRA is the timing of your tax break. For the traditional IRA, it’s when you file your taxes for the year of your contribution. For the Roth, it’s when you withdraw the money. Here are several reasons why you should prefer the Roth because of this difference.
- Tax rates are historically low now, and the national debt is huge and climbing, so there’s a pretty good chance that tax rates will be higher when you retire.
- Although typically your income will be lower in retirement, your taxable income may not be lower. First, you’ll probably get some Social Security benefits which may be at least partially taxable. Next, you may do some consulting or other part-time work even after you retire. Third, you will almost certainly have income from investments, and with the larger portfolio you need to fund retirement, that may generate a lot of taxable income. Fourth, many of your deductions will likely shrink or disappear by the time you retire – no child tax credit, lower mortgage interest deduction (if any), fewer (if any) business expense deductions, etc.
- Since you make Roth contributions with post-tax money, all of your contributions and all of the earnings they generate will be available when you retire. For the traditional IRA, you get back a portion of the money through your current tax benefit. If you spend rather than invest that tax benefit, your savings will be much smaller when you retire.
- Your workplace retirement plan is almost certainly tax-deferred (unless it’s the fairly rare Roth 401(k) plan), so a Roth IRA lets you diversify the tax treatment of your retirement accounts.
Taxes and Penalties
Another important difference is in how withdrawals are taxed or subject to penalties. These differences raise another reason to prefer the Roth.
- Although using retirement money before retirement is bad for you, if you’re in a real bind, the Roth IRA lets you use your contributions (and in many cases your earnings too) with no income taxes and no penalties. Thus, a Roth IRA can serve double-duty as part of your emergency fund.
RMDs and Age Limits
The different treatment of forced withdrawals and age limits on contributions raise these two reasons to prefer the Roth.
- The lack of RMDs means you can keep on earning tax-free returns on your Roth IRA balance, until you need the money, or until you leave it to your heirs upon your death.
- With more and more people continuing to work at least part time late in life, the Roth lets you keep contributing past the age-70½ limit on traditional IRAs.
The (Few) Cases When a Traditional IRA Is Better for You
If one of these is true for you, the Roth isn’t your better choice (if it’s even a choice at all).
- If your MAGI is too high, you aren’t eligible to contribute (directly) to a Roth IRA.
- If you’re less than five years from retirement and are opening a new IRA, you may not have access to any of the Roth money when you first retire, until the five-year countdown is over.
The Mix-and-Match Case
In principle, you can contribute to both types of accounts in the same year, as long as the total contribution doesn’t exceed your IRS-imposed limit for the year, and you’re eligible to contribute to a Roth IRA.
Thus, if for some reason you prefer a traditional IRA, there can be a case for contributing in parallel to both types of IRA. Specifically, if your income is too high for a traditional IRA contribution to be fully deductible, consider making a partial contribution to your traditional plan in an amount that can be deducted in full, and contribute the rest of your annual IRS limit to a Roth.
The Bottom Line
In almost all cases (assuming your MAGI allows it) you should prefer to contribute annually to a Roth IRA rather than to a traditional IRA. If you prefer the traditional IRA anyway, you would almost certainly do well to limit your traditional plan contribution to the amount you can deduct from your current taxes, contribute the balance of your allowed limit to a Roth (assuming again that your MAGI allows it), and make sure to invest in your taxable portfolio the tax benefit you got from making the deductible traditional plan contribution.