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By Christine Benz | 03-12-2014 10:00 AM

Key Factors in the IRA Debate

Financial-planning expert Michael Kitces explains why investors need to analyze current and future tax rates, RMDs, and estate plans when weighing options between Traditional and Roth IRAs.

Michael Kitces is a partner and the director of research for Pinnacle Advisory Group, and publisher of the financial planning industry blog Nerd's Eye View. You can follow him on Twitter at @MichaelKitces or connect with him on Google+.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. It's IRA season, and one of the key decisions facing investors is whether to invest in a Roth or Traditional IRA. Joining me to discuss that topic is financial-planning expert Michael Kitces.

Michael, thank you so much for being here.

Michael Kitces: Great to be here, thanks.

Benz: Michael, you put out a piece on your blog where you were looking at the decision about whether to contribute to a Traditional IRA or to a Roth IRA. It's IRA season, so people are contemplating which is the right contribution type to make. You outlined four key factors that should go into that decision making. The biggest one in your view is current tax rate versus what you expect your tax rate to be in the future.

Kitces: We've seen all of these different kind of discussions and framings around what's better, Roth versus Traditional. We tried to do some research and pulled together all of the different arguments, all the different threads, and all the different things that people say. And we really found that it comes down to only four factors, and one of them is really the dominating one: tax rates. It's simply to recognize at the end of the day, if we've got this money that we've earned pretax and we're trying to figure out where to send it, should we send it to the IRA or the Roth side?

If we send to the [Traditional] IRA side, we get a deduction now, we pay the taxes later. If we send it to the Roth side, we pay the taxes now, and then we don't have to deal with them later. That fundamental split really actually just comes down to: If you are going to pay the taxes now or you are going to pay the taxes later, pay the taxes when the rate is lower, and then you finish with more money.

Benz: The amount that you expect to contribute also should be a factor in the decision-making. Let's talk about how that works and why that would matter?

Kitces: The amount matters, but often not in the way that people think of it. So, I've seen a lot of people say things like, "I'm contributing a big amount, so I really want to do it in a Roth so it can grow tax-free." Or "I'm really optimistic about this investment, so I want to put it in a Roth to get the bigger growth rates on the tax-free side."

As it turns out that alone doesn't necessarily drive the factor. If it's a really big contribution and your tax rate is really high right now, you should get the really big tax deduction of contributing it to the Traditional side and then still paying your taxes later when they are lower, or likewise if, you are going to get a great growth rate, but it turns out your taxes would have been lower in the future, you still should've done the Traditional. That just means you would have gotten the great growth rate and saved even more by not contributing to a Roth.

Benz: Let's talk about the role of required minimum distributions in this decision-making. Obviously, if you're investing in a Traditional IRA, you are subject to those RMDs; Roth assets are not. So how should investors think about this decision? Most affluent inventors want to avoid those RMDs.

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