How to Decide Between a Roth or Traditional IRA

Christine Benz: Hi, I’m Christine Benz for Morningstar.com. Should you fund a traditional IRA or a Roth IRA? Joining me to discuss the differences and how to approach this decision is IRA expert Ed Slott.

Ed, thank you so much for being here.

Ed Slott: Great being back here. Thanks, Christine.

Benz: One topic we often hear from our users on Morningstar.com is this idea of Roth versus traditional. If you're in a position to fund either type of account, how do you decide? I want to start by discussing the differences between these two account types, because in some ways they really are quite opposite. Let's talk about that starting with the tax treatment.

Slott: Well, the basic premise--and just so you know, believe it or not, in January 2018, the Roth will be 20-years-old. And yet, it's probably not being used enough, but it's getting into the mainstream. The big difference is, where do you want to be in retirement--in taxable or tax-free territory? Now, if I ask you that, tax-free.

Benz: Right.

Slott: Tax-free is always better. That's an always rule. But you got to pay the price to get there. So, that's the difference. A traditional IRA is tax-deferred. That money hasn't been taxed yet, but it will as you go through retirement--and you are forced to take it out in retirement whether you want to or not because of required minimum distributions. Roth IRAs, when money gets in there and the only way money can get in there is with contributions or conversions, either way, the taxes have already been paid. So, the benefit you get, it's tax free in retirement, and there are no required minimum distributions. So, if that's most important to you, maybe you want to have more in a Roth or all in a Roth or hedge your bets.

Benz: Right. And split them across the account types.

Slott: Yeah.

Benz: I will follow up on that in a second. But first, there are also some differences on who can contribute to each account type. Let's talk about that.

Slott: Yeah. It's unusual or unintended, I don't even know what they do in Congress, but these are IRAs, yet everything about them is different. Obviously, the big difference is Roths are tax-free in retirement.

Benz: Right. And the RMDs, I think …

Slott: Right, and the RMDs. So, IRAs have RMDs, Roths don't. But the nuances, which you would think should be similar, are exactly opposite. That's the best way to understand this thing.

Benz: Right.

Slott: For example, traditional IRAs have age limits. For example, once you hit your 70 1/2 year or older, you can no longer contribute to a traditional IRA. There is no age limit for a Roth. You can keep contributing. Why? I don't know why.

Benz: If you have earned income, right?

Slott: Yeah, you have to have the earned income from salary, wages, self-employment income. But assuming all things being equal with an IRA and a Roth IRA, Roth IRAs have no age limit, IRAs do. Now, income limits, IRAs have no income limits. It doesn't matter how high your income is, you could make a $1 billion a year, you can still put money in a traditional IRA. Not so with a Roth. For some reason, Roths have income limits. They are very high, but there are income limits.

Now, plan participation is different. When I say plan, say, you're in a 401(k), that has no effect on your ability to contribute to a Roth IRA. It also--many people think it does--but it also has no effect on your ability to contribute a traditional IRA. So, why is that different? Well, people think it has an effect. The effect it has, it has an effect on your ability to deduct that IRA contribution if you are in a plan and your income is too high.

Benz: OK.

Slott: Then when you take the money out, everything is different, too.

Benz: Well, I want to talk about that because there are different rules about how your distributions are treated upon distribution. Let's talk about that.

Slott: Yeah. Before I get to that, one thing on the income limit. I said there's two ways to get money into a Roth, contributions and conversions. The income limit I talked about is only for the contributions. There was no income limit if you want to convert.

Benz: Which is that backdoor strategy that people have been using, which we'll touch on quickly. It's just that you contribute to a traditional nondeductible IRA, but then assuming you have no other IRA assets over here, you then convert it to Roth.

Slott: Right. So, now on the way out, strange rules also. For Roth contributions, not conversions, but for Roth contributions you can take your contributions out of your Roth IRA at any time for any reason …

Benz: Which is really generous.

Slott: … tax and penalty-free.

Benz: Right.

Slott: Not so with a traditional IRA. With a traditional IRA, you are going to have those age 59 1/2 rules. So, if you take it out early, you will pay tax and probably a 10% penalty. So, that's a big difference. That's a huge difference, especially for young people. That's the big sell on Roth contributions for young people. They don't have to wait till 59--I mean, it's better if you do, because that's the whole idea to build a nice tax-free retirement account. But if they needed it, the actual contributions, not the earnings or the conversions, can be withdrawn any time for any reason tax and penalty-free.

But there's also a difference between IRAs and Roth IRAs, how the money comes out. With Roth IRAs, they have what's called ordering rules. Certain types of Roth money come out first. So, the contributions are deemed to come out first, then the conversions, then the earnings. With traditional IRAs, it's so-called pro rata rule where every distribution is a percentage of basis back or your contributions or your money in and earnings.

Benz: OK. So, the big question is, if someone is in a position to contribute to either type of account, how do they make decisions about that? How do they decide, well, am I better off paying the taxes today and getting tax-free withdrawals in retirement or am I better off taking my tax break now and having to pay ordinary income tax when I take the money out in retirement?

Slott: Well, there are two factors that only you know. One, nobody knows what future tax rates will be. I think they are going to be higher. They are going to have to be higher. We're in an all-time low, may even go lower based on future tax legislation. But at some point, bills are going to come due in this country and rates are going to go through the roof. History has taught us that; Mark Twain had a saying, history doesn't repeat itself but it rhymes. We had 30 years ago 70%, 80%, 90% tax rates. So, if rates go up higher, the Roth is a hedge against what the uncertainty of future higher tax rates can do to your retirement savings just when you need that money the most. When you are the most vulnerable in retirement and paychecks stop. the last thing you want to do is pay 30%, 40% or even 50% tax when you need every dime of that money. So, that's one argument for the Roth.

Other people say, well, so what are future tax rates, that's the one we don't know, but I think they will be higher. And then other question is, what do you think your future tax rates are. That may be better known because you know what other assets you have, but you have to figure in required minimum distributions. So, that's the money you have to take that can bump up your rate. So, people think sometimes, well, when the paychecks stop, when I'm retired, I will be in a lower bracket, so I'm better off with a tax-deferred traditional IRA because when I take the money out, I will be in a lower bracket. So, two arguments for or against that; maybe you will be in a lower bracket and maybe taxes will be lower, but we don't know. Maybe you will be in a lower bracket but that lower bracket could be a higher bracket than today …

Benz: At a secular level, yeah.

Slott: … on a larger balance.

Benz: Right.

Slott: So, it's something--I'm a big believer in more certainty in retirement. That's why I like the Roth. To me, if I could get everything in the Roth and never have to worry about future tax rates and everything is tax-free forever for the rest of my life, I'm willing to pay the price for that now. Not everybody is. That's just my own opinion to remove the uncertainty of what future taxes can do to your retirement savings.

Benz: How about the idea of tax diversification in retirement. So …

Slott: If you want little of both.

Benz: … if I'm maybe a midcareer accumulator, I've been using the traditional tax-deferred accounts. Is there an argument for hedging my bets a little bit and splitting my contributions?

Slott: It's not an all or nothing.

Benz: Yeah.

Slott: Not an all or nothing. You can do some and have--I would definitely hedge the bets at a minimum. I wouldn't have it all tax-deferred in a traditional or tax-free in a Roth. Personally, I would have it all tax-free in a Roth. But for most people, if you are not sure about some of these things I talk about, what your own tax rate or bracket will be in the future and what you think taxes will be generally in the future for you or for the country, you may want to hedge your bets.

Benz: OK. Ed, thank you so much for being to discuss a really important question.

Slott: Thanks, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.