Christine Benz: Hi, I'm Christine Benz for Morningstar.
It's do or die time if you'd like to make an IRA contribution for the 2011 tax year. Joining me on the phone to discuss whether it's best to make a traditional or a Roth IRA contribution is retirement expert and author Ed Slott.
Ed, thank you so much for joining us.
Ed Slott: Great to be here, thanks.
Benz: Ed, the starting point if you are trying to squeak in a last minute IRA contribution, your financial services provider will ask you, what kind of contribution do you want to make? Do you want to make a Roth or traditional? And obviously, that's a big question, but what are some of the key factors that should go into that decision-making process?
Slott: Well, it is a big decision because it affects the rest of your life, especially if you're planning on having any decent size retirement account.
So what they're really asking you, forget about IRA or Roth, do you want tax deferred or tax free, and that's a big difference. Tax deferred is a traditional IRA where you make a contribution to your IRA, and it may or may not be deductible--that's something you have to look at also--and you get a current tax deduction. So you save a few bucks currently, but then, ... in fact you pay for it for the rest of your life. So, in my view, I think you are better off, most people, with a Roth IRA, where you don't get a tax deduction, but you contribute the money to a Roth, if you qualify--and that goes for both, the separate qualifications for both--and the money grows tax-free forever, income tax-free forever. So if I'm looking ahead to retirement, especially the younger you are, the more powerful a Roth is, because the Roth grows tax-free for the rest of your life, and then at retirement the last thing you want to worry about is taxes, and with a Roth you don't have to. But it comes with a cost. You have to pay for it upfront. You don't get a tax deduction. So you won't get that extra few bucks in your pocket at tax time.
Benz: So what if a person is getting fairly close to retirement and realistically is probably not going to be in a higher tax bracket in retirement then they are now because they haven't saved very much. For such a person would you still recommend a Roth or do you think a traditional IRA, if you can deduct the contribution, is the way to go?
Slott: Well, here's the thing. You hit on the most important point: What do you think future tax rates will be? Now people always say that, "Well, I'll be in a lower tax bracket in retirement because I won't have current income," but I have to tell you, for people who are the best savers, that's not even true now--because if you go to a traditional IRA, where you get the tax deduction and then in theory you'll be in a lower tax bracket at retirement, and then you take it out at a lower rate, you've done well. But first of all, we don't know what future rates are; given the state of our economy, you have to believe tax rates are going to go up. And it's not only that. Tax rates on retirement accounts are always taxed--the withdrawals from a retirement account--are always taxed at the highest rate--the ordinary income tax rate.
So, whatever the future rates are, you know you'll be at the top type of rates. Whether you'll be at the highest bracket, that depends on what the brackets are and your other income. But what we found is, people who are retired now that thought that are actually in higher tax brackets now, mainly because they are being penalized for all the savings they've been doing. People who are savers have larger IRA balances. With an IRA, at some point--that's why it's called tax deferred and not tax free--at some point you're going to pay the piper. We just don't know what those rates will be. But the problem with traditional IRAs, whether you want to keep saving or not, once you hit age 70 1/2, you are forced to start taking some of that money out, whether you need it or not, and paying tax at the prevailing rate, which is a big uncertainty.
So, to me a Roth IRA removes the uncertainty of what future tax rates might do to your retirement savings, because the future tax rates on distributions or withdrawals from a Roth IRA will be tax free; once you're 59 1/2 and have had the account for five years, it's tax-free. So, taxes aren't even a part of your retirement planning, which is really good. So, I still like the Roth IRA because it removes that big uncertainty of what future tax rates might be.
Benz: So you get tax-free withdrawals, no RMDs, and possibly some estate planning...
Slott: ... No RMDs, I didn't say that, but thank you for saying that. That's a big benefit to a Roth. Even at 70 1/2, you want to keep saving, keep saving. You are never forced to take that Roth money out during your lifetime. Your beneficiaries will be, but not you, so you can keep it growing for the rest of your life, tax free. You need it, you take it. You're in control. That's what I like about it, and that's especially important in retirement.
And for younger people and ... when I say younger people, [I mean] for people just starting in the workforce--20s, 30s--it's hands down. It's a no-brainer: Do a Roth. So, you miss out on a tax break and you won't get the tax savings this year, but if you take the traditional IRA, like I said before, you get a tax break up front, but you pay for it for the rest of your life, because all of that money that's going now in a traditional IRA is growing partly for the government. It's not all growing for you, because a lot of that is owed back to the government. That's not the case with the Roth. So, the Roth removes the uncertainty of future tax rates, and the tax rate in retirement would be zero.
Benz: Ed, thank you so much for sharing your wealth of insights on this very important topic. There are obviously lots of complexities, and it's great to have you here to help us navigate.
Slott: Thanks, Christine.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.