*The information contained in this post is not meant to be specific for you or your situation and is not meant to be financial advice, as I am not licensed as a financial planner. Before making any decisions, I strongly recommend speaking to someone licensed in this area to consider your unique situation. My recommendation in this area would be Will Butler.*
A couple of weeks ago I wrote my favorite post to date on the best student loan repayment option for those seeking financial independence. If you haven’t read that post yet and have student loans, I would encourage you to do so! The response I got from that post was interesting. Many people enjoyed how in depth I went with the calculations; some said that it was intriguing but wouldn’t work for their personal situation; others said that they had been searching for a post like that for a long time and it was very helpful; and several people said I was a moron for ever thinking about keeping debt for 25 years despite the numbers making sense in my favor. To each their own, I guess. There was another common response that surprised me though, and that was, “Why would you choose a traditional IRA over a Roth IRA?” That was only a very tiny portion of that post yet it drew quite a bit of attention. After explaining my reasoning and hearing rebuttals, I realized that many people don’t understand the difference between the two at all and blindly choose based on what their financial guru of choice tells them to choose. The guru’s advice (cough, Dave Ramsey, cough) is often very general in order to fit a wide audience and very rarely the best advice for each individual’s situation.
Sometimes I have a hard time deciding what to write on this blog because my audience seems to be split pretty much 50/50. Half of the readers are physical therapists and student physical therapists that are reading because they are interested in travel therapy. The other half are die hard members of the financial independence/early retirement crowd. There is a small subset of readers that fall into both of these groups, but that is not very common. Since I want this post to appeal to all of my readers, I’m going to look at each group separately when determining what is best.
Lets start with the basics in case there is some confusion on the difference between the two. It’s important to note that things change for people with higher incomes, but in this post I’ll just stick with how it works for the majority of the population.
- Traditional IRA – Contributions go in pre-tax, meaning that you don’t pay taxes on the money when the contribution is made. The money then grows in the account (using whatever investments you choose) tax free. Your contributions and the growth made while in the account are taxed as ordinary income when withdrawn. Any money withdrawn before the age of 59.5 years of age is assessed an additional 10% penalty on top of your tax rate. A Traditional IRA is very similar to a 401k.
- Roth IRA – Contributions are made with after-tax dollars, meaning that you pay taxes on the money before it ever gets put into the account. The money grows tax free (using whatever investments you choose) and is able to be withdrawn tax free. Contributions to the account can be withdrawn at any time without penalty, but any earnings made on your investments in the account cannot be withdrawn before age 59.5 without you being assessed a 10% penalty.
- The current yearly maximum contribution is $5,500 ($6,500 if over age 50) regardless of the type of account chosen. Contributions can also be split between the two accounts if you wish as long as the total doesn’t exceed $5,500.
In summary, with a Roth IRA you pay taxes on the money before it goes into the account, but can withdraw contributions and earnings without taxes at retirement age. With a Traditional IRA, you don’t pay taxes on the money when it is put into the accoun,t but you do pay taxes on the contributions and earnings when you withdraw it at retirement age.
How to Decide
The easiest way to determine the right account for you is to look at your marginal tax rate now and compare that to what you believe your marginal tax rate will be in the future. Since none of us (unless you believe in psychics) can predict what the tax brackets will look like when we retire, there is some educated guessing that goes into this. A very good indicator of whether you taxes will be higher now or later is to look at your current savings rate.
If you’re making $60,000/year, yet spending only $30,000, which is the case for many in the FIRE (Financially Independent Retired Early) crowd is doing, it is extremely likely that you will have a lower tax rate after retirement since you will only need to withdraw $30,000/year (inflation adjusted of course) to live on in retirement. Having a lower tax bracket after retirement compared to your current tax bracket is the ideal reason for choosing a Traditional IRA over a Roth IRA.
If you’re making $60,000/year and spending $55,000/year currently and you expect that you will be spending even more after retirement due to wanting to live on the beach and travel the world, then a Traditional IRA wouldn’t make sense for you. You will likely be in a higher tax bracket after retirement and would be better off paying taxes now and withdrawing the money tax free later.
Which is Best for You?
For the physical therapist readers, you could go either way here depending on your spending habits. If you save a decent proportion of your income (15-25%+) currently and plan to have a similar costing lifestyle once you reach retirement age, then a traditional IRA would probably be best for you since your tax rate will likely be lower in retirement than it is now. If you are mostly living paycheck to paycheck and aren’t able to save very much and plan for your retirement expenses to be similar to what they are now, then putting as much as possible into a Roth IRA is probably going to be better for you. If you’re somewhere in between these two scenarios, it might be a good idea to split your contributions 50/50 between the two in order to hedge your bets.
For the FIRE readers, it is very hard to argue against fully funding a Traditional IRA since, in order to achieve FIRE, your savings rate is obviously pretty high meaning that your tax rate will likely be lower after retirement than it is now. There is also a very good chance that by keeping your expenses low in retirement, you’ll be able to access the money in your Traditional IRA early without penalty and at a low tax rate. I don’t want to try to reinvent the wheel when the Mad Fientist has already done such an awesome job at explaining how this is possible in his article. This is personally the route that I am choosing to take with my financial plan.
Common Arguments on the Topic
It seems that many financial advisers as well as individuals knowledgeable on the topic have their own opinion on what is best. Here are some things that I’ve heard mentioned when discussing which account is best.
- “Do you trust the government to not increase taxes over the next 40 years? No way would I gamble with what future tax brackets and rates might be, it’s better to pay the taxes now with a Roth IRA and not have to worry about future tax hikes.”
- On the surface this seems like a valid argument. The future is definitely uncertain. It seems like taxes have increased over the years, right? Actually that incorrect. The reason it seems like taxes have increased is because of inflation. In reality, the effective tax rate for the median household income (~$56,000/year) has decreased over the past 70 years in inflation adjusted dollars. Anything is possible, but if the past 70 years are any indicator, we shouldn’t count on taxes increasing significantly in the future at the median household income. (Here’s a cool site a found where you can enter your current income and see what your tax rate would have been throughout history).
- “Since Roth IRA contributions can be withdrawn at any time without penalty, a Roth is best since you can use your contributions in case of emergency.”
- This is an absurd argument in my opinion. Instead of taking money out of a retirement account where it can grow tax free, you should have a big enough emergency fund or a plan to cover unexpected expenses so that you don’t have to touch your retirement savings regardless of the type of accounts it’s in.
- “Reducing tax liability today using a Traditional IRA saves you money at your marginal tax rate today, since it’s being subtracted off the top of your current income, while being taxed at your effective tax rate later since the money withdrawn from the account will first be used to fill up the lower tax brackets.”
- This is true and a solid point in favor of a traditional IRA in my opinion. Let’s look at an example to illustrate this using a single individual with a gross income of $65,000/year (a fairly common starting PT wage). At $65,000/year you would be firmly in the 25% tax bracket. That means that by contributing to a traditional IRA now, you would reduce your federal tax liability by 25% of the amount you contribute since it’s taken off the top. Now fast forward to retirement age and say you still want to live off of $65,000/year (in inflation adjusted dollars). Since we can’t predict the future, let’s assume the tax brackets are the same in the future as they are now. Now when you withdraw that $65,000 from your Traditional IRA (still assuming being single to not complicate things), the first $10,400 of that amount would be tax free due to the $6,350 standard deduction and $4,050 personal exemption. The next $9,325 would be taxed at 10% to fully fill that bracket. The next $28,625 would be taxed at 15% to fill that bracket. And only the last $16,650 would be taxed at the 25% marginal rate. This leads to an effective tax rate of only 14.15%. You would reduce your current tax liability at an effective 25% tax rate while paying only a 14.15% effective tax rate on the same amount at retirement. If this seems like gibberish to you, don’t worry, it took me a long time to realize the difference between marginal and effective tax rates as well. Check out this article that should hopefully give you a little better understanding of the difference between the two. **Keep in mind that this scenario is assuming that there is no other earned income in retirement which may or may not be the case for you depending on your situation. Having earned income could change things by a little or by a lot depending on how much it is.**
- “You expect to make more money throughout your career, don’t you? Then a Roth IRA makes sense because it’s taxed now.”
- When I was in PT school I went to the Virginia Student Conclave one year, and this is an almost word for word quote from a financial advisor speaking there on Roth vs. Traditional IRA. This seemed to make sense to me and I wrote in the notes I was taking, “Always use a Roth.” The problem is that whether or not your income increases during your career doesn’t matter, what matters is what your income will be in retirement which is directly related to your expenses. It would be foolish to start making IRA withdrawals while you’re still working and in a high tax bracket later in your career, so that is a foolish argument.
The last tid bit I want to add on IRAs (regardless of which type you choose), is that it is important to remember to contribute to your 401k up to the employer match before contributing to either a Traditional IRA or a Roth IRA. The employer match is free money and is always going to be your best return on investment.
Deciding between a Roth IRA and a Traditional IRA is not as simple as choosing a Roth IRA because Dave Ramsey says it’s best. I believe that for the majority of people, a Traditional IRA is the superior option unless you expect huge lifestyle inflation after retirement. If your tax rate is higher now than it will be in retirement, a Traditional IRA is right for you. If your tax rate is lower now than it will be in retirement, a Roth IRA is right for you. You should sit down and think critically about your own situation and what your life looks like now and what it will likely look like after retirement, otherwise you’re shooting blindly. And remember, always take advantage of the employer match in your 401k if available.
Were you aware of the difference between these two accounts? Which account do you currently contribute to and why? Did you think about your current and future tax bracket when making your decision or did you just take the advice of someone else who told you it was the right thing to do? Thanks for reading!