Which is Better: Roth IRA or Traditional IRA?

I frequently get asked about the differences between Traditional IRAs and Roth IRAs, and which one is the best choice for retirement savings.  Unfortunately, the answer is not black and white, and is dependent on your own situation.  For this reason, educating investors on the differences between the two accounts becomes even more valuable.  In addition, I will explain the key factors I look at when helping clients with this decision.  If you are unsure about which type of IRA is suitable for you, then I’d suggest you read to the end.   

Key Takeaways:

·       Roth IRA vs Traditional IRA Analogy

·       Comparing the two options

·       Using a “Backdoor” Roth IRA

·       Qualifying contributions

Roth IRA vs. Traditional IRA Analogy

I wanted to start the blog with the differences between the Roth IRA and Traditional IRA.  To do so, let’s cover an analogy that takes place on a farm.  If you knew that you were going to have a very good harvest, which would you rather pay tax on?  The seed or the harvest?  Most people answer the seed, but there are some flaws in this thought process.  Through this decision, you are assuming that the tax rates are going to be the same for both the seed and the harvest. 

However, we know that in the US, the more you make, the higher your taxes go up.  Another thing to consider is that we don’t know what tax future tax rates will be.  Our tax laws are usually only enacted for a certain period as legislation frequently changes.  For example, our current tax laws are set to expire in 2025 and the new administration has already stated that they plan to change it. 

In the analogy above, the Roth IRA was the option where you paid tax on the seed, while the Traditional IRA was the option where you paid tax on the harvest.  If we knew what the future tax rates (until death) were going to be, then it would be an easy decision.  People would want to pay tax on the seed and let the crop grow for a long time, and that crop growing is the market value of your account.  So, investing in the Roth IRA would be the obvious decision.   

Comparing the Two Options

Now that we have a better understanding of the differences between the Roth IRA and Traditional IRA, let’s explore how each type of account works in more detail.  With a Traditional IRA, you make contributions to the account with pre-tax dollars, meaning that you can deduct the amount of your contribution from your taxable income for the year in which you made the contribution.  This reduces your taxable income, which can lower your overall tax bill for that year.  You won’t have to pay taxes on your Traditional IRA contribution until you withdraw the money from the account, which you can start doing penalty-free at age 59 and a half. At that point you’ll pay taxes on the withdrawals as ordinary income. 

On the other hand, a Roth IRA is funded with after-tax dollars, which means that you don't get to take a deduction on your taxes for your contributions. However, the benefit of a Roth IRA is that all your withdrawals in retirement are tax-free if you meet certain requirements. Additionally, you can withdraw your contributions (but not your earnings) at any time without penalties or taxes, which can be useful in emergencies.

It's important to note that there are income limits associated with both types of accounts. For example, with a Traditional IRA, if you or your spouse has access to a retirement plan through work, your ability to make deductible contributions may be limited based on your income. Similarly, with a Roth IRA, there are income limits that determine whether you're eligible to contribute to the account at all. If your income is too high to contribute to a Roth IRA directly, you may be able to make a non-deductible contribution and then convert it to a Roth IRA later, a strategy known as a backdoor Roth IRA.

Finally, it's worth noting that while both types of IRAs offer tax advantages, they may be better suited for different types of investors. For example, if you expect to be in a lower tax bracket in retirement than you are now, a Traditional IRA may be the better option. However, if you expect to be in a higher tax bracket in retirement or if you want more flexibility with your withdrawals, a Roth IRA may be the better choice. It's important to work with a financial advisor to determine which type of account is best for your specific situation.

Using a Backdoor Roth IRA

If your adjusted gross income is higher than the limit for direct contributions to a Roth IRA and you still want to make a Roth contribution, you may want to consider using a backdoor Roth IRA. This involves making a non-deductible contribution to a traditional IRA and then converting it to a Roth IRA. Essentially, you're making a Roth contribution, but it must start going into the traditional IRA. You need to have a traditional IRA as a non-deductible contribution, and then you convert it to a Roth contribution.

It's important to note that if you have any IRA monies, such as a traditional IRA, SIMPLE IRA, or SEP IRA, those will be counted in the calculation of whether this money is taxable when you convert it. If you have no traditional IRAs in your name, then there's no calculation on the conversion, so it doesn't cost you any tax to do this. However, if you do have a traditional IRA balance, you'll need to determine how much of the conversion is taxable. To do this, divide the contribution (up to the traditional IRA contribution limit of $6,500 in 2023, with a $1,000 catch-up contribution for those age 50 or older) by the IRA balance. For example, if you contribute $6,500 and have a traditional IRA balance of $100,000, only 6.5% of the conversion would not be taxable, and the remaining 93.5% would be taxable.

When you convert the non-deductible traditional IRA contribution to a Roth IRA, you'll owe taxes on the amount that's converted. The amount you owe depends on your federal tax bracket and, depending on where you live, any applicable state taxes. For example, if you're in the 22% federal tax bracket, converting $6,500 to a Roth IRA would cost you about $1,430 in federal taxes.  Therefore, it would cost you $1,430 to convert this money into a Roth IRA.

However, it's important to consider the taxes you paid to earn the money, because money going into a Roth IRA is money that you've already paid tax on.  To get the $6,500 you plan to convert, you would have had to have $8,333 (6,500/.78 due to the 22% tax) of earned income.  Which means you would have paid about $1,833 in taxes when you earned the money, and an additional $1,430 when you went to convert the funds.  Therefore, you should calculate the total tax amount you will pay to convert the funds before determining the best course of action.

In summary, using a backdoor Roth IRA can be a good strategy for high earners who want to contribute to a Roth IRA, but it's important to consider the tax implications. If you don't have any traditional IRA balances, then the conversion won't cost you anything in taxes. However, if you do have a traditional IRA balance, you'll owe taxes on the amount that's converted based on your federal tax bracket, which could be a significant amount. Ultimately, it's best to consult with a financial advisor or tax professional to determine if a backdoor Roth IRA is the right strategy for your situation.

If you are interested in Backdoor Roth IRAs, then you should check out my past podcast, How a Mega Backdoor Roth Can Accelerate Your Retirement Savings, #87.  

Qualifying Contributions

When it comes to deciding between a Traditional IRA and a Roth IRA, it’s important to consider your adjusted gross income and whether you qualify for a deduction and/or Roth contribution. Remember, that to contribute to either of these accounts, you must have earned income.  This would include W2 or Self-employed income.  However, sources such as Social Security, pension, dividends, interest, and annuity payouts are not included as qualifying earned income.

It's worth noting that Traditional IRA holders are subject to Required Minimum Distributions (RMDs) which start at age 73.  The starting age was recently changed from age 72 to 73 with the Secure Act 2.0.  Therefore, another great benefit of the Roth IRA is that you will not be subject to RMD’s if you opened and funded the account.  However, non-spouse beneficiary Roth IRAs are subject to RMDs.  In this case, the recipient of the account must fully draw down the account within ten years from the date of death.  Otherwise, they will be subject to fees and additional taxes. 

 Lastly, I want to finish with some blanket advice.  The decision to contribute to a Roth IRA or Traditional IRA should be made annually.  It requires the analysis of several factors such as income level, tax bracket, and retirement goals so what made sense last year may no longer make sense this year.  Therefore, it’s alright to have a mixture of pre and post-tax funds that you can withdraw in retirement.  If anything, it will work to your benefit as you could strategically take distributions from either account in retirement dependent on your taxable income to reduce taxes incurred. 

Thank you for taking the time to read this blog post and learn more about the differences between a Roth IRA and a Traditional IRA.  If you still have questions or concerns about which option is best for you, don’t hesitate to reach out to me.  As a Certified Financial Planner and host of the Retire with Ryan podcast, I have helped countless clients make informed decisions about their financial futures.  I am passionate about working with individuals and families to create personalized financial plans that align with their unique goals and values.  I have included a direct link to my Calendar so schedule a free consultation and take the first step towards securing your financial future!