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Traditional vs. Roth


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2011 Oct 18, 10:25am   13,923 views  42 comments

by swebb   ➕follow (0)   💰tip   ignore  

I have read a lot of web articles on how to decide between a traditional and a Roth IRA. While there are many complexities, one of the big "rules of thumb" seems to be that if you expect to be in a higher tax bracket when you retire than you are currently, use a Roth, otherwise use a traditional. For example (plucked from a web page):

"Again, if the taxpayer were in the same tax bracket before and after retirement, there would be no benefit or advantage to either IRA."

This is a point I have considered many times, and one I have discussed with "knowledgeable" people, and have never had a satisfactory conclusion. Admittedly, my understanding of tax law is limited, but as I understand it, the marginal tax bracket is most important on the contribution side, and the average tax bracket (if that makes sense) is what matters on the distribution side. By way of example, if an individual can afford a $4000 contribution in pre-tax dollars, and is in the 25% marginal tax bracket, consider the two investment options.

1. Invest $4000 in a traditional IRA, with no taxes deducted.
2. Invest $4000 - $1000 (25%) in a Roth IRA.

When it comes time to take a distribution, assume the person is in the same 25% marginal tax bracket. For the traditional IRA, the first portion of their income (I presume) is taxed at 10% the next portion at 15%, and the rest is taxed at 25%. (this is, of course, assuming tax brackets stay the same). Compared to the Roth IRA which paid 25% tax on all contributions, the traditional IRA paid

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22   Dan8267   2011 Oct 20, 7:41am  

thomas.wong1986 says

At least they quote their sources which is hyperlinked to government publications. Good source as a first start.

In an article on something mundane as IRAs, you're probably safe using the references. However, I would warn against using Wikipedia as a starting point for references in general. If the article is misleading, then the set of references will be skewed to point you in the direction the authors want, which may be deliberately misleading.

I'd rather get my references directly from Google. Although not perfect by a long shot, at least Google is much harder to hijack for political or economic purposes.

23   corntrollio   2011 Oct 20, 8:06am  

Dan8267 says

Your analysis in that post assumes that a person would contribute less in a Roth IRA because of the tax. This is not typically the case.

Yes, I stated that's the assumption, and then I stated that if you actually contribute up to the Roth limit (assuming you aren't exempted out), you'll end up ahead based on that. Did you read the following sentence:

corntrollio says

I'm in the same net position. The difference is that I can actually put $5K in my Roth, so it's like having a Traditional IRA of $6250.

Dan8267 says

Furthermore, the difference is even greater if you take a realistic lifetime of growth, which would likely be much more than 150% in nominal terms.

It doesn't matter what the number is. Multiplying 0.8 * 18 million * X is the same as 18 million * 0.8 * X. But yes, if the first X is bigger than the second, sure.

Dan8267 says

I'd rather get my references directly from Google. Although not perfect by a long shot, at least Google is much harder to hijack for political or economic purposes.

The problem is that Google's formula tends to get hijacked by Wikipedia. It also gets easily hijacked by extremely low quality parked sites or sites which only mirror other sites' content (although I thought recent algorithm changes were supposed to eliminate that...).

The other thing I've noticed (which might be related) is that Google is very good for relatively common questions, but is less good on more complex questions or finding something very specific, and on those searches you start getting lots of irrelevant results. I feel like I used to be able to dig up better stuff back in the day than I can now on Google when doing these sorts of inquiries.

Something where you could search within the same sentence or same paragraph or within some number of words (as you could with something like Lexis -- e.g. http://www.lexisnexis.com/help/global/US/en_US/connect_frameset.asp ) and where you could refine your search within existing search results (I'm not sure if doing this manually yields the same results, at least Google's results counters seem inconsistent if this does work) would be useful for power users. Currently you get a lot of scattershot irrelevant stuff on Google under the current formulas.

24   marcus   2011 Oct 20, 3:08pm  

EBGuy says

A maxed out Roth is probably the best solution for them. It's the same reason for buying a home and using it as a inflation hedged savings account. It works, because you have to do it.

For me with a 403b (basically the same as a 401 K) the max is 16K + plus the 5500 (catch up provision) for being over 50. That's 21,500. Since I don't save that much, even before tax, this makes more sense for me than a Roth.

In other words, I am saving more this way pretax, which obviously is 25% more than I would be putting in a Roth type account, with the same (saved) earnings. Still using Controllio's 20% bracket asssumption. And 100 is 25% more than 80 (25% of 80).

corntrollio says

Well, again, assuming the tax rate is the same, if you are not putting more than $5K minus effective tax rate in your Roth, then you will be in the same position with Traditional IRA or Roth IRA

Yes, I understand. Didn't I say in my post you were right ?

If I can save more this way, I will. I am under the assumption that my taxes will be lower. I know my income will be. I expect tax rates to be higher then, but not much on incomes like the one I will have.

Besides, I wouldn't be surprised if they even have special lower rates for seniors 10 + years from now, for seniors who don't have enough savings, and because the senior boomers will be such a big voting block. There is a problem with boomers not having enough put away. Some special tax consideration, especially on incomes under say 50K would be an easy bone to throw them.

25   clambo   2011 Oct 21, 2:44am  

Roth is better because you do not KNOW what will happen to tax rates when you are retired. They have to throw out the Roth completely to make it taxable, and there may be a big fight over this. Raising tax rates is much easier and this will affect the traditional IRA.
I have not converted my old IRA completely however, but all new money goes into a Roth IRA.
You can skip the whole issue and buy a "tax efficient" fund from Vanguard but that seems just boring somehow :) Then, you will be taxed at capital gains rates when you spend it down.

26   JimP   2011 Oct 21, 2:51am  

For the higher effective tax concern.

http://www.news-journalonline.com/opinion/editorials/2010/05/14/taxing-social-security-amounts-to-double-taxation.html

Here is a calculator: http://www.calcxml.com/do/inc08

The threshold is low and hasn't been adjusted for inflation so many people can't avoid this anyway, but bottom line is at certain income range, you will be paying tax for every dollar distributed from IRA and that same dollar will increase taxable social security benefit by one dollar, up to 85% of benefit. So IRA can increase ss benefit tax while ROTH wouldn't - you can verify with calculator.

27   corntrollio   2011 Oct 21, 9:30am  

clambo says

Roth is better because you do not KNOW what will happen to tax rates when you are retired. They have to throw out the Roth completely to make it taxable, and there may be a big fight over this. Raising tax rates is much easier and this will affect the traditional IRA.

I think you have this exactly reversed. Roth IRAs are the ones that are the relatively new creation that Congress could blow away at any time. Similar case for Roth 401(k)s.

28   clambo   2011 Oct 22, 3:27am  

I disagree. There is not that much money out there invested in Roth IRAs. So, they would have a giant political fight to throw out the Roth entirely but without the huge revenue they would like to achieve from taxing it. On the other hand, *some* Americans will always be working, and taxable capital gains will also be flowing, so I believe the politicians would go after taxing income and cap. gains first.
I could be wrong. I have a regular IRA, Roth, Sep IRA, an old variable annuity, index funds and some non index funds. It's a bit of a mess but it beats the alternative.

29   corntrollio   2011 Oct 24, 5:00am  

clambo says

There is not that much money out there invested in Roth IRAs. So, they would have a giant political fight to throw out the Roth entirely but without the huge revenue they would like to achieve from taxing it. On the other hand, *some* Americans will always be working, and taxable capital gains will also be flowing, so I believe the politicians would go after taxing income and cap. gains first.

If there's not that much money in it, why would there be a big political fight? If anything that suggests there'd be a bigger political fight for non-Roth.

In addition, they could get money from changing the treatment of Roth -- by going after cap gains tax on it.

30   everything   2011 Oct 27, 10:15am  

Roth is a great way to suck you into the markets permanently since they'll ding you for taking the money out in some cases. Kind of a backward investing mentality when you think of it, but Wall Street has you, you know it, and they know it. Even with a deferred comp plan you take money out and get both penalties and taxes. Then, they attach an age bracket to the investments as well, stating you can't take the money until so and so age, without penalties, gotta laugh..

If the stock market went up every day like it did today, we would all be millionaires within a month.

31   corntrollio   2011 Oct 27, 10:21am  

everything says

Roth is a great way to suck you into the markets permanently since they'll ding you for taking the money out in some cases.

Not true. You could invest in a CD if you don't want to invest in the stock market, as you suggested in another thread.

You can take out principal untaxed from a Roth IRA because you already paid tax on it.

everything says

Even with a deferred comp plan you take money out and get both penalties and taxes. Then, they attach an age bracket to the investments as well, stating you can't take the money until so and so age, without penalties, gotta laugh.

Sure, and you knew that going in. If you didn't want tax deferral, why did you put it in there in the first place? If you instead pocketed the money, you would pay tax on it, and then you would pay capital gains tax on any investments you made with it upon sale, instead of having the advantage of deferral.

32   JimP   2011 Oct 28, 3:46am  

everything says

Roth is a great way to suck you into the markets permanently. . .

Secondly, what does this have to do with the OP question? Also, the same can be said for both Roth and Traditional IRA.

everything says

Even with a deferred comp plan you take money out and get both penalties and taxes. Then, they attach an age bracket to the investments [ROTH IRA?]as well, stating you can't take the money until so and so age, without penalties, gotta laugh..

Got a point here. I don't know the penalty rate, but it seem Traditional IRA early withdrawal the penalty may be applied to the principal and the earnings, while for ROTH the penalty should be applied only to the earnings. So if you think there is a chance you will need to pull out some money before retirement, ROTH should be better.

33   SFace   2011 Oct 28, 5:09am  

JimP says

Got a point here. I don't know the penalty rate, but it seem Traditional IRA early withdrawal the penalty may be applied to the principal and the earnings, while for ROTH the penalty should be applied only to the earnings. So if you think there is a chance you will need to pull out some money before retirement, ROTH should be better.

10% penalty for non-qualified reasons

It's a fair rule. without the penalty, there is nothing to stop income shifting and play around with tax brackets and rates.

Let's say I'm self employed and made 200K in one year so I contribute 45K in SEP IRA, saving about 20K in federal and state tax, then the next year, I decided to take the year off not make any $$ and withdraw 20K from the IRA instead, that IRA is not taxable anymore due to income. So I saved 20K in tax year 1 but pay nothing in year 2 even though in the end I contributed nothing to the IRA.

34   pkennedy   2011 Oct 28, 5:36am  

I'm betting if you're making 200K in a year running a business you've got better ways of hiding money. Even if you take 20K out and you have a 10% penalty, it is probably far less than the 35% tax bracket you were in the year before.

Now if you're making 20K/year and you all of a sudden have a vacation coming up and you're short.... Well this is a great place to get some money, especially if it's just like an ATM machine and since you're years away from retiring, you'll get it back in there... Oh wait, there is a penalty...

That scenario I have seen played out. The penalty being about the only thing stopping them. The penalty makes it more of a one way door for many people, which is what it should be.

35   Seattle Investor   2011 Oct 28, 5:54am  

I believe you're overthinking it swebb.

The only tax bracket that matters is your marginal tax bracket. To use your example, at the 25% tax rate with the 4K pretax contribution amount:

Roth: 3K goes in and 3K comes out (of principal, obviously)

Traditionial: 4K goes in and 3K comes out.

If tax brackets are the same then distributions are the same. Your investment decisisons should not be affected by your IRA type.

Don't forget to anticipate how tax rates will change between now and when you retire. Current tax rates are very low from a historical standpoint.

36   corntrollio   2011 Oct 28, 6:18am  

pkennedy says

I'm betting if you're making 200K in a year running a business you've got better ways of hiding money. Even if you take 20K out and you have a 10% penalty, it is probably far less than the 35% tax bracket you were in the year before.

Not in the 35% bracket unless you are in the AMT phaseout (28% + 25% phaseout = 35%). In fact, if you are married, $200K in profits running a business means you're not even in the 33% bracket (even beyond the fact that AGI is what determines bracket).

37   Jon137   2011 Oct 28, 6:28am  

One of the reasons I don't think there will ever be a flat tax is because if there is, everyone holding a ROTH will be screwed.

swebb says

That's the "problem" I'm having. Partly because I have been very frugal lately, partly because I didn't contribute to my IRA last year (I had some risks to hedge against. They didn't come to pass, but it seemed prudent) which left me with excess $....

That was probably not a good move. Look at it this way, in your situation your maximum risk was 10% (the penalty for early withdrawal, assuming you took 100% of the money out for that year).

If your risk scenario came to be, more likely you take the hit for the exact amount you need and you still leave the rest in, so likely the hit would have been less than 10%. Mabye 5% or whatever. But now the remainder can go on to earn for you tax-deferred.

38   corntrollio   2011 Oct 28, 9:20am  

Jon137 says

One of the reasons I don't think there will ever be a flat tax is because if there is, everyone holding a ROTH will be screwed.

You mean if the flat tax is in the form of a consumption tax or VAT-style tax?

The flat tax could also be in the form of an income tax, in which case no harm no foul.

39   Jon137   2011 Oct 29, 3:41am  

corntrollio says

You mean if the flat tax is in the form of a consumption tax or VAT-style tax?

The flat tax could also be in the form of an income tax, in which case no harm no foul.

I don't think there will ever be a flat income tax. We already have a flat tax (capital gains) and it provides a very good case study of why such taxes simply don't work. One size fits all taxes heavily favor the rich.

40   swebb   2011 Oct 29, 4:36am  

Seattle Investor says

I believe you're overthinking it swebb.

The only tax bracket that matters is your marginal tax bracket. To use your example, at the 25% tax rate with the 4K pretax contribution amount:

Roth: 3K goes in and 3K comes out (of principal, obviously)

Traditionial: 4K goes in and 3K comes out.

If tax brackets are the same then distributions are the same. Your investment decisisons should not be affected by your IRA type.

I still think it is more complicated than this. Assume all of my contributions into the Roth are at the 25% tax rate. So for the contribution side the "penalty" for using a Roth is 25% (that I could have deferred if I used a traditional IRA). When it comes time to take my distributions, also assume that my marginal tax rate is 25%. By the way taxes are assessed, I only pay 25% tax on the portion of my income that falls in the 25% tax bracket. Assuming todays tax brackets for "married, filing jointly", that would mean that my first $17,000 would be taxed at 10%, the portion between $17,000 and $69,000 would be taxed at 15%, and the portion above $69,000 would be taxed at 25%. In this way the taxes I pay at the time of distribution is significantly lower than the 25% marginal tax bracket.

As an example, if I made $100,000 I would pay:
0.1 * 17,000 + 0.15 * 52,000 + 0.25 * 31,000 = 17,250 (17.25%)

As someone else pointed out, Social Security income is taxable in some situations, and would have to be figured in to the above.

I think the simplification that most people make is to assume that if you are in the 25% tax bracket then *all* of your income is taxed at that rate, when in reality it is only the marginal income that gets taxed at that rate. That's my understanding, anyway -- and if correct it is an important consideration in making the Roth vs traditional decision. (I'm using both for various reasons)

s

41   swebb   2011 Oct 29, 4:43am  

Jon137 says

That was probably not a good move. Look at it this way, in your situation your maximum risk was 10% (the penalty for early withdrawal, assuming you took 100% of the money out for that year).

You make a good point, something I probably didn't understand fully when I made my decision. The other mitigating (?) circumstance is that because I now have a 401K plan available at work (new this year), I have an additional $16,500 I can contribute (Roth or traditional), in addition to a SEP 401k that my wife has access to. This puts our total contribution limit into the $30k + range, which is enough "room" to get last years (deferred) contribution in with the same tax advantage, without really affecting how much I can/do contribute this year. I do, of course, lose the year opportunity of my money growing.

So while it still might have been the better choice to put it in last year, I don't think it makes too much of a difference. And, maybe I'm just rationalizing.

-s

42   corntrollio   2011 Oct 31, 9:46am  

swebb says

I think the simplification that most people make is to assume that if you are in the 25% tax bracket then *all* of your income is taxed at that rate, when in reality it is only the marginal income that gets taxed at that rate.

Yes, I can't believe some people still believe this, but I see this time after time in those articles about taxation. I remember when Obama was running for president, you'd have quotes from "business owners" who claimed they made $250K (in sales, not in profits, so really they didn't) and that all of their income would soon be taxed at 36% or 39.6% because of Obama. These people are too idiotic to be successful business owners.

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