Traditional IRA vs Roth IRA

Traditional IRA vs Roth IRA: which is better? In most cases, a Roth IRA creates a lower lifetime tax bill, but a shrewd investor can still make more money with a traditional IRA by investing yearly tax savings.

To answer the question of traditional IRA vs Roth IRA, an investor has to answer a few questions. Generally speaking, a Roth IRA will result in a lower lifetime tax bill. A shrewd investor who invests their annual tax savings, however, can make a traditional IRA grow them a bigger pile of money.

Below, we’ll show an example in which someone with a Roth IRA pays $278,330 less in taxes over their lifetime than someone with a traditional IRA. However, we’ll also show an example where someone with a traditional IRA winds up with almost $68,000 more than someone with a Roth IRA, despite the higher tax bill. It all depends on how it’s handled.

Specifically, someone with a traditional IRA who invests their annual tax savings can do better than someone with a Roth IRA. so even though they pay more taxes, they get richer in the end.

Most Financial Advisors Think a Roth IRA is Better Than a Traditional IRA

roth ira rules rothMost financial advisors generally think a Roth IRA is better than a traditional IRA. Why? Because of the way each kind of IRA handles taxes.

Tax differences are the biggest ways Roth IRAs and traditional IRAs differ from each other. Traditional IRAs offer investors a tax savings now, while Roth IRAs most often provide a much larger tax savings later. This one key difference means Roth IRAs provide a bigger tax savings overall. Therefore, Roth IRAs are usually the favorite of most financial advisors.

We’ll look at the specific tax differences between Roth IRAs and traditional IRAs below.

How traditional IRA Taxes Work

SIMPLE IRA contribution limits different typesTraditional IRAs are often attractive to those trying to save money for retirement because they offer a tax break in the same year the money is put into the IRA. For example, in 2015 the maximum contribution for a traditional IRA is $5,500 for those younger than age 50 and $6,500 for those age 50 and over.

A 45 year old who deposits the maximum contribution into an IRA account in 2015 gets to deduct the entire amount of that contribution from their taxes in that year. That means someone who otherwise had $50,000 in taxable income in 2015 but maxed out their 2015 traditional IRA contribution limit will only have to pay taxes on $44,500 of their income. That’s a nice tax break.

How Roth IRA Taxes Work

roth ira rules no required minimum distributionsA Roth IRA is designed to give investors no tax break now, but a larger tax break later. Roth IRA contribution limits for 2015 are the same as traditional IRA contribution limits: $5,500 for those younger than age 50 and $6,500 for those age 50 and older.

The big difference between Roth IRAs and traditional IRAs is that Roth IRAs offer their tax breaks during retirement. That means someone who puts $5,500 into their Roth IRA in 2015 sees no tax break in that year. So if the investor has $50,000 in taxable income in 2015 and puts $5,500 into their Roth IRA, they still have to pay taxes on all $50,000 of their income.

However, when the investor starts drawing money from their Roth IRA during retirement, the money comes out tax free. We’ll show below how this means a Roth IRA will generally provide a bigger lifetime tax savings than a traditional IRA.

Roth IRA vs Traditional IRA: Why Most Financial Advisors Pick Roth

ira contribution limits roth based on traditional iraLet’s look at an example of two investors. They both invest the same amount, but one picks a traditional IRA and the other chooses a Roth IRA.

Let’s say each investor puts the maximum amount allowable into their respective retirement accounts. In 40 years of saving, they’ll both put $5,500 a year or $220,000 total into their IRAs. Assuming they invest the money at 6%, they’ll each have about $902,000. Not bad. However, investor A puts his money in a traditional IRA and investor B puts her money in a Roth IRA. Investor A with the traditional IRA will pay $278,330 more in taxes over his lifetime than investor B.

Here’s How Roth IRAs Usually Mean Less Taxes Than traditional IRAs

save on child care tax creditLet’s look at the way each IRA handles taxes to see why most advisors pick Roth IRAs over traditional.

The traditional IRA in our example above gave investor A a nice tax break every year. Assuming a 25% tax rate, he saved $1,375 a year in taxes. In 40 years of saving, that’s a total of $55,000 tax dollars saved.

While that’s a nice savings, when both investors start to take the money out of their IRAs during retirement, investor B now has access to $902,000 in tax free dollars. Investor A meanwhile has to pay taxes on the $902,000.

If both investors were to live on $50,000 a year for the next 20 years, investor A would have to withdraw $66,666 a year to get $50,000 a year after paying 25% in taxes. Investor B would only have to withdraw $50,000 a year because her taxes have already been paid.

roth ira rules taxAfter 20 years, investor A would pay $333,330 in taxes on his traditional IRA. Compare that to the $55,000 investor B paid when making contributions to her Roth IRA.

All together, the investor with the Roth IRA pays $278,330 less than the investor with the traditional IRA. Nice, right? But it’s not the whole story. If the goal is to make sure Uncle Sam gets as little money as possible, then a Roth IRA is clearly the way to go. If, however, the goal is to build as big a pile of money as possible, then a traditional IRA might be better. Keep reading to find out why.

Traditional IRA: Pay More Taxes, Make More Money

start saving early retirement compound interestWe said above that someone with a traditional IRA who makes the maximum contribution of $5,500 a year will save $1,375 a year in taxes at a 25% tax rate. We also said that person will pay $278,330 more in taxes over their entire lifetime than a similar investor who chooses a Roth IRA.

That’s true if the investor takes that $1,375 a year and spends it on creature comforts, vacations, luxuries, groceries gas or an increased standard of living. In short, if the investor spends that $1,375 a year, the Roth IRA is definitely the way to go.

But what if that investor takes that $1,375 a year and diligently sticks it into another investment account? Investing that money at a rate of 6%, the traditional IRA investor will have an additional $225,500 by retirement age. Coupled with the $902,000 from his traditional IRA, the traditional IRA investor now has a $1,125,500 total retirement fund. The investor with the Roth IRA still only has $902,000.

start saving for retirement early save moreNow let’s assume both investors start taking money out of their retirement accounts at age 60 and that they’ll need $50,000 a year to live. Assuming that 25% tax rate still holds, investor A will need to draw out about $66,666 a year from his traditional IRA to get $50,000 after taxes. Investor B will only have to take $50,000 a year from her Roth IRA, because the Roth IRA funds are tax free in retirement.

Assuming each investor lives another 20 years, even though the traditional IRA investor paid $278,330 more in taxes, he still has more money than the Roth IRA investor.

As the table below shows, as long as the traditional IRA investor can keep earning 6% interest, his retirement fund will keep growing despite his sky-high tax bill.

Traditional IRA vs Roth IRA

In the table below, the first column shows the investor's age. The second column shows how much money the traditional IRA investor will have in our example if he invests his yearly tax savings. The third column shows that he'll have a lot less retirement money if he doesn't reinvest the savings. The last column shows that a Roth IRA investor does better than a traditional IRA investor who doesn't reinvest his tax savings, but worse than a traditional IRA investor who does invest his tax savings. This example assumes a 25% tax rate and that each investor is trying to live on $50,000 a year during retirement.
AgeTraditional IRA WITH Invested Tax SavingsTraditional IRA WITHOUT Invested Tax SavingsRoth IRA

Roth IRA vs Traditional IRA: Some Advisors Say “It Depends”

Our math above makes a traditional IRA look like the clear choice, as long as the saver invests the annual tax savings. But what if the investor can’t get a 6% return on the invested money? What if tax rates go up or down? What if they need more or less than $50,000 a year to retire on? All these factors should make investors think a little deeper than our example, digging into the numbers of their exact situation.

As the video below from Vanguard explains, it may all come down to the tax rate.

Traditional IRAs vs Roth IRAs Other Facts

The table below gives the basic differences between Roth IRAs and Traditional IRAs for more details about contribution limits and deduction limits for both kinds of IRAs, see the links below the table.
 Traditional IRARoth IRA
2014 and 2015 IRA Contribution Limits$5,500 for those under age 50.
$6,500 for those age 50 and over.
$5,500 for those under age 50.
$6,500 for those age 50 and over.
2014 and 2015 IRA Income LimitsNo additional income-based contribution limits.Single filers: Modified AGI must be less than $129,000 in 2014, less than $131,000 in 2015.
Married filing jointly: Modified AGI must be less than $191,000 for 2014, less than $193,000 for 2015.
Tax RulesContributions are tax deductible in the year they are made. Distributions are taxed as income.Contributions are not tax deductible. Distributions are not taxed.
Withdrawal RulesWithdrawals before age 59 1/2 carry a 10% IRS penalty. Distributions must start by age 70 1/2.No penalty for early withdrawal. Withdrawals are never required.

As stated in the table above, the contribution limits for both traditional and Roth IRAs are identical. For more info on Roth IRA contribution limits and income limits, click here. For more info on traditional IRA contribution limits and income limits, click here.