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Which is Better for Me: a Roth or Traditional IRA?

The choice between a Roth IRA and a Traditional IRA depends on available discretionary income and financial situation. Both IRAs have the same contribution limits.

The Traditional IRA goes in pre-tax (generally), grows tax-deferred, and is taxable as income on withdrawal. The Roth goes in after-tax, grows tax-deferred, and is not taxable upon withdrawal.

That’s the primary difference.

This will allow you to lower your current taxable income by making Traditional IRA contributions, which may seem more appealing in a number of ways. There’s the effect of immediate gratification that leads investors to favor this way, and the fact that you’re technically paying more (by the amount of taxes you paid on the after-tax Roth) to make the same current contribution to a Roth.

The Roth offers sweeteners to the deal in a few ways, however. The contributions made to a Roth can always be accessed and withdrawn, without owing taxes or penalties for early withdrawal – but note that this is only the contributed amount that gets this treatment, and early withdrawal of gains will be subject to taxes and the 10% early withdrawal penalty.

Roth distributions in retirement are also not included in calculations of Adjusted Gross Income (AGI) that are used to compute taxes to social security benefits and exposure to the 3.8% medicare surtax. Roths are also not subject to RMDs at age 70 ½, while Traditional IRAs are.

Those are just the fundamental differences, but how these retirement vehicles work within your financial plan will require looking at your own numbers, and possibly asking for the help of a professional.

One thing to consider is that you may not be eligible for a Roth or a Traditional IRA. For Traditional IRAs, you may not be able to make deductible contributions if you or your spouse is covered by a qualified plan at work, depending on your combined income.

There are also income limits that may restrict you from contributing to a Roth, but there is actually a method called a Back-Door Roth that may give you an opportunity to fund one. A back-door Roth requires a conduit Traditional IRA to be set up that merely takes the investment cash and holds it momentarily before it is converted to a Roth.

Since deductions are never taken for the Traditional IRA contributions in this scenario, the contributions go after-tax into the Roth, and no other footwork is required. It is unclear if this “back door” will remain open long.

If you are making lots of pretax contributions to a plan at your job, or have a sizable 401(k) left over from a past job, it may make sense to fund a Roth, to help balance out your tax exposure in retirement and give you a tax-free bucket to pull from.

As always, it is best to consult a professional if you are unsure about which IRA is the right choice for you.

 Disclaimers and Limitations

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