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Long time Money.SE lurker, time for my first question.

I'm young and this is the first time I am in a position where I can comfortably max out ($5,500) my contribution to an IRA for 2016. I am trying to decide between Roth and traditional. I already understand the differences between the two, so that is not my question. This really boils down to:

I already know I will be opening a Roth 401k in 2017 and I have no IRA accounts. I can get an extra $1000 back on my 2016 taxes by simply moving $5,500 into a traditional IRA. Is this a good idea or am I being blinded by the quick thousand bucks?

I understand the appeal of tax free growth, but in 40 years will this decision actually matter?

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You should choose Roth vs. Traditional based on your current marginal tax rate, generally. As such, and as you've indicated you have a 25% marginal rate, I would suggest traditional.

Most people in retirement who saved well will pay an average tax rate something in the 15-20% range. Average tax rate is important here: total income divided by total dollars tax paid. That's how much you're paying on the money you're withdrawing.

On the other hand, marginal tax rate is what's relevant for when you save it, because that's what you'll save by choosing traditional - you're looking at just the rate for the last few dollars. Doesn't matter what you paid on average this year, just the rate you'd pay on the dollars you're putting in the IRA.

If your marginal rate is 25%, then you probably should choose traditional - you'll probably end up with more money at the end of the day that way, assuming tax rates stay the same, and you don't end up super rich (and if you do ... congrats, and odds are you won't care about a few thousand dollars from 2017 being taxed each year). If your marginal rate is 15%, then you choose Roth, as odds are you'll pay more than 15% average rate (or at least you probably won't pay much less, and you'll benefit from diversity).

The final note is diversity has some value, if you're on the cusp of one or the other. You can be smart in retirement and withdraw some from Roth some from regular, in order to balance your overall tax rate, particularly if you have better and worse years in your non-IRA income (if you have some non-IRA investment income, or continue working part time or consulting or whatnot). I don't think diversity has a huge value, so don't choose Roth even when you're at 28% just to get some diversity, but if you're on the edge of Roth vs IRA, it might make a small difference in my choice.

But don't forget you may have a chance to convert to Roth down the road, particularly if you have a lean year where you're unemployed six months or something - you can take advantage of that year's low tax rate to convert your traditional-saved-25% IRA to a Roth and pay 15% on the conversion.

Edit: I meant to include a link to JoeTaxpayer's excellent article on the subject, one of several on his site covering the choices and techniques related to Roth vs. traditional IRAs.

  • I specifically leave out details about other uses of Roth by the way - including allowing withdrawing principal penalty free - as I find that to be a net negative if anything. Anything that encourages you to spend IRA money before you retire is bad in my book. – Joe Jan 26 '17 at 23:55
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The normal way of thinking about Traditional vs Roth changes once you are talking about maxing out your contribution.

If you are in a position to max out your IRA, and you can't decide whether to go with Roth vs Traditional, then as a rule of thumb I would lean towards Roth since you are effectively putting more money away. The same logic goes for a 401K too if you have the option and are able to max it out either way.

Another (probably minor) benefit of going with the Roth IRA is to get it on record just in case the 5 year rule would ever apply to you.

That being said, what you would do with the $1000 savings may be relevant too. If you can pay off a high interest debt with it but otherwise couldn't, that might tip the scales towards the traditional IRA. Another exception to the rule would be if you are in a high tax bracket today but have good reason to believe you won't be when you retire.

  • I have no debt at the moment and the $1000 would probably end up being dumped into my brokerage account's target date mutual fund.... Or spent on a set of golf clubs :) All signs seem to point to the Roth, however. – user45579 Jan 26 '17 at 22:55
  • @drewm. - hehe. Agreed. – TTT Jan 26 '17 at 23:02

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