IRAs: Roth and the Other Kind

Poke around the blogosphere and personal finance punditocracy and you will find lots of positive references to Roth IRAs and virtually no nice things said about its dull older brother, the traditional IRA. If you didn’t know any better (and why would you?) you might assume that the younger and hipper Roth IRA was the way to go. After all, it is the cool new thing and the latest in retirement savings technology. Here’s a rundown of the differences and why you are likely to want to go with the unhip kind after all.

IRAs come in two basic flavors. There is the traditional old-style IRA, in which you put pre-tax money, i.e. your contributions are tax deductible, and then later in life pay taxes on your withdrawals as if they were income. And there is the relatively newer type, a Roth IRA, in which contributions are post-tax, i.e. not deductible, but withdrawals are tax-free.

Which is for you? Obviously, you want the one that will wind up making you more money. To tee that up, consider the following.

Tom Traditional and Robbie Roth have identical incomes, and so pay identical tax rates, and they both have $3,000 a year of that income that they wish to put in an IRA. Obviously, each picks the type that matches their name, so Tom puts in the full $3,000 each year and Robbie puts in $2,250 after paying taxes of 25%. The years pass, and they make identical investment decisions until they retire on the same day. Tom’s account is, of course, larger but he needs to pay 25% taxes on anything he takes out, while Robbie can withdraw tax free. Here’s the big question: after Tom pays taxes on his withdrawals, who has more money to spend?

The answer, which seems to surprise a lot of people, is that they have exactly the same amount of money. Assuming the tax rate going into the Roth is the same as the one coming out of the traditional, the financial benefit of the accounts is exactly the same. Fire up Excel and run the numbers yourself if you don’t believe me.

So why do the advocates of saving seem to universally prefer Roths? It’s not about numbers, it’s about conceptual appeal. Saving is about sacrificing now for a benefit in the far-off future. With a Roth, you pay taxes now so you can not pay taxes later, and that has a big attraction to the savings crowd.

Symbolism aside, there are good reasons to choose one type of IRA over the other. Primarily, which one is better depends on the tax rate you pay now and the one you will pay when you are retired. Tom and Robbie came out equal because they always paid 25%. If the tax rate had been 25% when working but only 15% during retirement, then Tom would have wound up ahead because he would avoid the 25% and only pay 15%. Conversely, if the rates were 25% while working and 35% when retired, then Robbie would be better off.

Occasionally you see the pro-Roth argument that given the fiscal problems the government has now and is likely to have in the future, tax rates will inevitably rise. That sounds perfectly reasonable, but it is worth reflecting that the same thing could have been said for the past 30 years and so far it’s been wrong. Predictions of what Congress will do in future decades is hardly a sound basis for your retirement planning.

On the other hand, predictions of how much money you will be making in retirement, and so which tax bracket you will be in, are more practical. If you have a Roth, you are betting that your income, and your tax rate, will be higher in retirement than it is now. That’s some bet. (You do understand that in retirement you won’t have a job, don’t you?) Furthermore, choosing a Roth over a traditional is doubling down the bet on your own future prosperity. If you wind up being a rich retiree, you’ll be happy you have a Roth because you won’t pay high taxes on the withdrawals. But if you wind up a poor oldster you’ll wish you’d picked traditional, because you’d have more money, even after paying the (lower) income taxes on what you take out.

There are other factors to consider when choosing between the two types of IRA. (There’s a nice rundown here and here.) But they are all secondary to the tax rate issue and some of them are pretty esoteric. In the big picture, what matters are tax rates now and when retired. And for many, if not most, people that means that an old-school traditional IRA is a better choice, even if it lacks hipness and the frugal appeal of paying more now for a benefit far in the future.

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