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With a traditional IRA, you are taxed on the complete balance of your account when you cash out after retirement correct? This would mean you are taxed on contributions + interest earned.

With a Roth since you put post-tax money in and aren't taxed when withdrawing, doesn't this mean you only pay taxes on your contribution amount? This seems like a huge advantage for a Roth to the point where I can't figure out why anyone would choose a traditional.

Am I thinking about this correctly? Assuming you can max out a Roth contribution and you don't expect to be in a significantly lower tax bracket at retirement, it seems like the Roth is a no-brainer. Maybe those 2 stipulations are the reasons not everyone chooses a Roth, but those 2 stipulations don't seem too difficult to meet.

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First of all, it's pretty rare that would cash out your entire Traditional IRA at once when you retire. That would incur major taxes and negate much of the tax deductibility benefit. Instead, you'd want to take distributions of just what you want to live on, which are taxed at income rates, and let the rest continue to grow tax free until you need/want it.

As to your main question, if you don't expect to be in a lower tax bracket in retirement, then yes, Roth makes sense. But this is a pretty major assumption. When you're working, your salary pushes you into higher tax brackets. Once you're retired, you don't have as many sources of income. It could be mostly distributions from retirement accounts, and even coming from a Traditional IRA a lot of that will be tax free or taxed at a low rate (e.g. 15%). If when it was earned it would have been taxed at a higher marginal rate (e.g. 25%), then the Traditional IRA was a better choice than the Roth.

Traditional versus Roth, if both are options to you (with deductibility for the Traditional), all comes down to tax rate now versus what you expect your tax rate to be in retirement. There is no universal answer.

  • Thanks for the answer. Something clicked in my head and I realized I've been thinking about retirement tax rate completely wrong this whole time. In my head I've been thinking of my retirement tax rate as the tax rate I'm at the year that I retire from my job (which would hopefully be higher). But now I see (obviously) that your retirement tax rate is based on what you are bringing in from retirement sources not including your job you used to have. – Adam Johns Jul 12 '14 at 2:50
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    @AdamJohns Just be glad you figured it out now rather than after you retire! – Craig W Jul 12 '14 at 2:51
  • but it is true that roths are only taxed on contributions and traditionals are taxed on contributions and earned interest right? – Adam Johns Jul 12 '14 at 2:54
  • @AdamJohns Yes, although it'd be more accurate to say Traditional IRAs are taxed on distributions, which will include both contributions and earnings. This is a bit of a red herring though--what you really want to focus on is the last paragraph of my answer (tax rate now vs. in retirement). – Craig W Jul 12 '14 at 2:57
  • Why is this a red herring? If I can max out a Roth won't I be doing my future self a favor? Assuming same tax rate now as retirement. – Adam Johns Jul 12 '14 at 3:21
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This seems like a huge advantage for a Roth to the point where I can't figure out why anyone would choose a traditional.

You are missing something called the time value of money. This is the concept that a certain amount of money now has the same value as a bigger amount of money later. Basically, you wouldn't be willing to give up an amount of money now and get the same amount of money later -- you need to get a larger amount later to be willing to exchange it for a certain amount now. So that larger amount later has the same value to you than that smaller amount now. This is the idea behind interest and investment returns.

When you make an investment, and it earns interest or gains over a period of time, in effect that final amount of money (principal + interest) has the same value as the principal when you started, because that final amount was grown from the original principal.

So whether you are taxed on the principal in the beginning (as in Roth IRA) or on the principal + interest at the end (as in Traditional IRA), you are still taxed on the same value of money. And if the tax rates are the same between now and in the future, then you pay the same value in taxes in both cases. Roth would only be better than Traditional if the tax rates are lower now than when you take it out; and Traditional would only be better than Roth if the tax rates are higher now than when you take it out.

Let's consider a simple example to demonstrate that the two are equivalent if the tax rates (assuming a flat tax, because tax brackets introduce other complications) are the same now and when you take it out. In both cases, you start with $1000 pre-tax wages, you invest it for 10 years in a place with guaranteed 5% returns per year adn then take it out, there are no penalties for withdrawal, and there is a flat 25% tax now and in the future.

  • Traditional IRA: You start with $1000 pre-tax and put it in the IRA. It grows for 10 years, to $1000 * 1.05^10 = $1628.89. You are taxed on 25% of it, leaving $1628.89 * 0.75 = $1221.67.
  • Roth IRA: You start with $1000 pre-tax. You pay 25% income tax on it, leaving $750 which you put in the IRA. It grows for 10 years, to $750 * 1.05^10 = $1221.67. No taxes are paid when you withdraw it.

Note that you are left with the same amount of money in both cases. This arises from the associativity of multiplication.

Note that Roth IRA has a higher effective "limit" than Traditional IRA, because the nominal limit is the same for both, but Roth is post-tax. So if you contribute to near the limit, where Traditional can no longer match the value that Roth can contribute, then the comparison no longer applies. The $1000 in this example is below the limit for both.

  • So if I can contribute fully to the Roth it will be better for my future self if I choose Roth right – Adam Johns Jul 12 '14 at 15:04
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Craig touched on it, but let me expand on the point. Deposits, by definition, are withheld at your marginal rate. And since you can choose Roth vs Traditional right till filing time, you know with certainty the rate you are at each year.

Absent any other retirement income, i.e. no pension, and absent an incredibly major change to our tax code, I know your starting rate, zero. The first $10K or so per person is part of their standard deduction and exemption. For a couple, the next $18k is taxed at 10%, and so on. Let me stop here to expand this important point. This is $38,000 for the couple, and the tax on it is less than $1900. 5%. There is no 5% bracket of course. It's the first $20K with zero tax, and that first $18,000 taxed at 10%. That $38,000 takes nearly $1M in pretax accounts to offer as an annual withdrawal. The 15% bracket starts after this, and applies to the next $57K of withdrawals each year. Over $95K in gross withdrawals of pretax money, and you still aren't in the 25% bracket.

This is why 100% in traditional, or 100% in Roth aren't either ideal. I continue to offer the example I consider more optimizing - using Roth for income that would otherwise be taxed at 15%, but going pretax when you hit 25%. Then at retirement, you withdraw enough traditional to just stay at 10 or 15% and Roth for the rest.

It would be a shame to retire 100% Roth and realize you paid 25% but now have no income to use up those lower brackets.

Oddly, time value of money isn't part of my analysis. It makes no difference. And note, the exact numbers do change a bit each year for inflation. There's a also a good chance the exemptions goes away in favor of a huge increased standard deduction.

  • But if I'm able to max out a Roth it still seems like I'll have more money at retirement right? – Adam Johns Jul 12 '14 at 15:07
  • Not really. Of course if you are comparing say, $5K to Roth vs $5K to traditional, the Roth will have the same amount but with no tax due. But. The correct comparison compares the gross deposits, $4000 to Traditional vs $3000 to Roth for one in the 25% bracket. Make sense? – JoeTaxpayer Jul 12 '14 at 18:02
  • Yeah makes sense. I unfortunately don't qualify for a deductible IRA though. My wife would though I suppose since she isn't covered by a retirement plan at work. Also there is the practical matter of being disciplined enough to invest my upfront tax break which I'm not sure I would end up doing. – Adam Johns Jul 12 '14 at 18:11
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    Different issues really. For your wife, if you go pretax and deposit the tax refund into the next years IRA deposit, you can use a mix. Without knowing your exact details, can't say what's ideal. – JoeTaxpayer Jul 12 '14 at 18:18
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One thing people are missing is that you may not be eligible to contribute to a Roth IRA based on your MAGI. There are income "phaseout" ranges which determine how much, if it all you can contribute.

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