Traditional vs. Roth IRA: Some Unconventional Wisdom on Which is Better for Young Investors

Traditional vs. Roth IRA Some Unconventional Wisdom on Which is Better for Young Investors

When I was fresh out of college and starting my first job, my dad convinced me that I needed to start saving for retirement. Even if it was just a little bit, getting started early was important. Thanks dad!

At the time I was working for a small start-up without an employer-provided retirement plan, so I needed to figure things out on my own and quickly found my way to the IRA. What an ingenious little device! A retirement account you can set up on your own and invest pretty much however you want? Pretty cool!

So I went about setting one up and quickly found that I needed to make a choice. Did I want to open a Traditional IRA or a Roth IRA? I went out in search of advice and found the response to be pretty much unanimous: a Roth IRA was the way to go. The logic was the same no matter where I looked and went like this:

  1. I was young and in a low tax bracket.
  2. Someday I would be older and in a higher tax bracket.
  3. Given that, I should pay the taxes now to get tax-free income later.

Makes sense right? It did to me. So I opened up a Roth IRA and happily stuffed it with money for years without so much as a second thought.

But over the years I continued to learn, and in that time I’ve discovered that the logic that leads people like myself to a Roth IRA is flawed. In fact, the Traditional vs. Roth IRA debate looks a lot different when you actually run some numbers and see the results.

So today I want to show you the truth behind the Traditional vs. Roth IRA debate in the hopes that you can make a more informed decision than I did when I started out.

Why the conventional wisdom is harmful

Let me get this out of the way. As long as you’re saving for retirement you’re doing a great job. As I said in my series on how to start investing from scratch, the most important decision you can make is to get started, not which IRA you choose. That has not changed.

With that said, the end goal of investing is to have saved as much money as you need within the timeframe you need it. If there are easy ways to make that more likely, you should take advantage of them.

The problem with the conventional wisdom in the Traditional vs. Roth IRA debate is that it’s mathematically incorrect, and it therefore leads a lot of people down an inefficient path. It’s not a bad path, it’s just that for many people there is a better one that will help them reach their goals more easily.

In order to explain where the conventional wisdom goes wrong and how we should be thinking about it instead, I’m going to have to back up a little bit and make sure we all understand some of the basic definitions first. For that reason, this post will be a little longer than normal, but I hope you stick with me because the conclusion can make a big difference in your retirement planning.

What’s the difference between a Traditional IRA and a Roth IRA?

There are several ways in which a Traditional IRA differs from a Roth IRA, but today I’m only going to focus on the biggest difference. If you’d like a more comprehensive list, including guidelines for whether you are actually eligible to contribute to either one, you can check out this resource: Which IRA is right for you?.

The biggest difference between a Roth IRA and a Traditional IRA has to do with how they are taxed.

Traditional IRA taxation

Any money contributed to a Traditional IRA is treated as a tax deduction in the year of the contribution. This lowers your taxable income for the year, giving you an immediate benefit.

As an example, if you’re a married couple in the 15% tax bracket and you contribute the maximum $11,000 to a Traditional IRA for 2013, you will save yourself $1,650 in taxes for 2013 (0.15*11,000).

The flip side is that when you actually reach retirement and start taking money out of the account, those withdrawals will all be taxable.

Roth IRA taxation

The tax treatment for a Roth IRA is exactly the opposite.

Your contributions to a Roth IRA are not deductible and therefore do not save you any money on this year’s taxes.

On the other hand, your withdrawals in retirement are 100% tax-free. In other words, you pay your taxes now in order to be tax-free later.

Understanding different kinds of tax rates

The last thing I want to talk about before I get into the real meat of the comparison is the difference between a marginal tax rate and an effective tax rate.

Don’t worry, I’m not going to get too technical here. But understanding this difference is crucial to making a true comparison between a Traditional or Roth IRA.

Marginal tax rate

marginal tax rate is the tax you will pay on your last dollar of income. If you’re in the 15% tax bracket, your marginal tax rate is 15%. Your last dollar earned was taxed at 15%, and if you earn another dollar it will be taxed at 15%.

Effective tax rate

But you didn’t pay 15% in taxes on your entire income. In fact, with the standard deduction and personal exemptions, there’s a good chunk of your income that you didn’t pay any tax on at all. And because of our progressive tax code, there’s another chunk of it that was only taxed at 10%. So your effective tax rate is the percent of your total taxes paid over your total income, and will be significantly lower than 15%.

An example

Let’s look at a simple example of a married couple with 1 child earning $53,000 per year. Their marginal tax rate is 15%. But what’s their effective tax rate?

You can look at my worksheet here to see the calculations, but the end result is that the couple’s effective tax rate is only 6.5%.

So what’s the real Traditional vs. Roth IRA Comparison?

Okay, now that we’ve gotten all of those definitions out of the way, it’s time for the real meat of the article: how you should really be making the decision about contributing to a Traditional IRA vs. a Roth IRA.

Please keep in mind that this conversation applies in the same way if you have the choice between a Traditional 401(k) and a Roth 401(k).

The conventional wisdom behind the Traditional vs. Roth IRA comparison looks at your marginal tax rate today against your marginal tax rate in the future. This is wrong.

What you need to do instead is compare your MARGINAL tax rate TODAY with your EFFECTIVE tax rate in the FUTURE.

That’s because any contributions to a Traditional IRA save you money at your marginal rate today, but any future withdrawals are taxed at your effective rate.

Let’s look at an example. You can follow my calculations and change some of the variables in this workbook here: Traditional IRA vs. Roth IRA.

For this example, I’m going to assume that all of our tax policies will stay the same over the years. This clearly won’t happen, but since we have no idea what WILL happen it doesn’t really make sense to speculate. I’m also going to ignore inflation, which just makes things more complicated and doesn’t materially affect the end result.

Finally, I’m ignoring the possibility that you have a pension or that you will receive Social Security income, since most young people don’t have a pension and Social Security is not guaranteed. The existence of either of those would change the calculations below in favor of a Roth, though not necessarily fully in favor of it.

In this example we’re using the same married couple we used above making $53,000 with one child, which puts them in the 15% tax bracket. We’re assuming they could contribute the maximum $11,000 per year allowed for a married couple to a Traditional IRA. With a Roth they would have to pay taxes on that $11,000, so their annual contribution is only $9,350 ($11,000 * (1 – 0.15)).

The conventional wisdom says that the 15% tax bracket is low and they should therefore contribute to a Roth.

So how does it actually play out? Well, when we actually run the numbers, as you can see in the spreadsheet linked above, we discover a few things that really challenge the conventional wisdom.

First of all, after 30 years of saving for retirement the balance in the Roth IRA is $1,143,934. Using the standard 4% withdrawal rule to determine how much they can take out each year in retirement, that would give them a $45,757 annual income in retirement. That is 100% tax-free.

With the Traditional IRA, their balance after 30 years is $1,345,805. It’s about $200,000 higher because they were able to contribute more because of the tax-break. But the withdrawals are taxable, so that’s not the full comparison.

To get the final comparison, we have to first calculate the 4% withdrawal for the Traditional IRA, which comes out to $53,832 per year before taxes. Notice that this is almost the same as their $53,000 in income during their working years. (These numbers were not chosen by accident).

The conventional wisdom would argue that because your income is essentially the same, and therefore your marginal tax rate is the same, it shouldn’t make a difference whether you contributed to a Roth or a Traditional IRA. Does that hold up?

When we take taxes out of that $53,832 per year, we find out that our withdrawal ends up being $49,650 after-tax. So let’s do a quick comparison of the results:

Traditional vs. Roth IRA

I don’t know about you, but I would rather have that extra $3,893 of income every year.

What’s the reason for this difference?

The big reason why the Traditional IRA comes out ahead has to do with the difference between marginal and effective tax rates that we talked about above.

In this particular example, the Roth IRA contributions would be taxed at the MARGINAL rate of 15%, while Traditional IRA contributions would be tax-free.

At the other end, the Roth IRA withdrawals would be tax-free while the Traditional IRA withdrawals would be taxed at an EFFECTIVE rate of 7.8%.

So by going with a Traditional IRA in this example, the couple would essentially be choosing to pay 7.2% less in taxes, even though their marginal rate would be the same at each point in time. Over 30 years of saving that adds up to a significant difference.

Conclusions

Now let me be clear. This doesn’t mean that a Traditional IRA is always better than a Roth IRA. There are many variables that might make your specific situation different from the example shown here. Some of those variables will tilt the scales in favor of a Roth IRA. Others will tilt them in favor of a Traditional IRA. A true personal evaluation will be more nuanced than what’s presented here.

But what should be clear is that the conventional wisdom behind the Traditional vs. Roth IRA debate is wrong. You cannot simply compare your tax rate now to your expected tax rate in the future. Doing so drastically underestimates the value of a Traditional IRA.

One of the biggest financial decisions you will make is how to save for retirement. My hope is that this helps you make a more informed decision.

If you’re interested in learning more on this topic, you can check out these two articles I wrote as a follow-up:

Photo courtesy of Iam Nicole

Share on FacebookShare on Twitter+1Pin it on Pinterest
Share this post
DID YOU ENJOY THIS ARTICLE?
Sign up to get my latest email updates and receive your copy of my eBook, ‘A New Parent’s Guide to Saving for College’, free!

71 comments… add one

  • DC @ Young Adult Money January 6, 2014

    Thanks for sharing your views, Matt! I’m actually planning a couple posts on this very topic, as I’m opening an IRA for the first time this year.

    • Matt @ momanddadmoney January 6, 2014

      Nice! Looking forward to hearing your thoughts. Which way are you leaning right now?

  • John S @ Frugal Rules January 6, 2014

    Solid post Matt! I think it’s easy to get caught up in the Roth vs. Traditional debate when so much of what we hear is championing the Roth. I’d agree with you that the saving is important, but you also need to take a serious look at your specific situation and what is going to serve you best. I didn’t see it in the post, but what are your thoughts on tax diversification?

    • Matt @ momanddadmoney January 6, 2014

      Hey, no skipping ahead to future posts! Haha. I did not discuss tax diversification, or many of the other variables that go into this decision simply because I wanted to make sure I hammered home this one specific point. But I think tax diversification is certainly a worthwhile consideration and plan on addressing it in the near future. The reality is that neither this nor any other single point should make the entire decision for you, but hopefully there’s a little less misinformation out there now than there was before.

  • MyMoneyDesign January 6, 2014

    Darn! You beat me to it. My Traditional vs Roth 401k post isn’t scheduled to go live until next week.

    Regardless, great write up! It’s amazing how much our funny tax system can complicate our understanding of these concepts. A lot of times I think the media just finds it easier to pitch these blanket statements like “a Roth is better” without really considering the factors.

    • Matt @ momanddadmoney January 6, 2014

      Haha! Yes! I win!!! Just kidding. I’m looking forward to your write-up as well.

      I think the media is definitely part of the problem, as is people’s desire for simplicity. Comparing marginal rates is relatively easy to explain and think about. Comparing marginal vs. effective is more effective and nuanced and makes for a less catchy tagline.

  • Michael Solari January 6, 2014

    Yes, Matt great post! Like with most financial planning, one size doesn’t fit all.

  • Brian @ Luke1428 January 6, 2014

    Nice post Matt! We have two Roths, a 403(b) plan (which I don’t contribute to anymore) and a traditional plan through my wife’s work. I’m pleased how these are doing and more pleased that we get a match through my wife’s traditional plan. Nothing like free money!

    • Matt @ momanddadmoney January 6, 2014

      Man, I’ve never had an employer match before. It feels like an oasis at this point. All the more reason to make informed decisions with our IRAs though.

  • Ree Klein January 6, 2014

    Another mind-blowing post, Matt, and this is exactly why I love reading your blog!

    I’ve often wondered which one was really be the best option. While you make an important point that each person’s situation might be different, you’ve clearly laid out tax implications in a way that makes absolute sense to me. I’d never heard it explained like that before!

    Thanks!
    Ree

    • Matt @ momanddadmoney January 6, 2014

      Thank you Ree! I definitely hope that people evaluate their own unique situation to make the decision that’s best for them personally, but hopefully this helps them make it with slightly more accurate information.

  • Done by Forty January 6, 2014

    Really interesting comparison, Matt. There’s a part of me that wishes the comparison showed the same $5,500 max contribution, because if you have $5,500 to put in your Traditional IRA (goes in post-tax, and you get the deduction at tax time) then by deduction you do have the $5,500 to go into your Roth.

    Additionally, might the argument made that the Traditional withdrawals are also going to be made at the marginal tax rate? That is to say, a retiree is going to have some sort of taxable income in all likelihood, rental income, maybe he works a part time job he likes, he has a pension that pays him some amount, whatever. The choice on how much to withdraw from his traditional IRA might, if we choose to look at it that way, be made AFTER those taxable incomes are made…so in that way they’d be adding on at the marginal rate of 15%, or what have you.

    • Matt @ momanddadmoney January 6, 2014

      You make two good points. On the first one, I’m actually addressing this exact question in a subsequent post, but the mathematically correct comparison would be maxing out the Roth to maxing out the Traditional PLUS putting the tax savings in another investment vehicle. If the other investment vehicle is a 401(k) or similar, then the argument remains. If it’s a taxable account, it gets more complicated. But in reality, people might be making the exact decision you’re describing without considering investing the tax savings from a traditional IRA. In that case the Roth will come out ahead simple because you’re saving more after-tax money.

      And yes, for some people their Traditional withdrawals will be at their marginal tax rate. That’s the caveat I tried to put in there about pensions and Social Security, along with the warning that there are plenty of other variables to consider in addition to what I discuss here. The reality is that the decision is more nuanced and personal than this one point, but I really just wanted to make sure that the automatic comparison of marginal rates is, in many cases, misguided.

      But the kind of thinking you’re doing here is exactly the kind of thinking that I hope everyone does. Whether it’s this article or a different one, there’s no way that something you read can describe your personal situation exactly. Good financial planning requires that you do your own self-analysis in order to make the best decision. Thanks for the contribution!

  • If looked at in isolation, I think you’re right. But I’m not sure most people are planning on funding a retirement solely on $5000 yearly contributions to an IRA. For us, our IRA is merely a “top up” account that we plan on using for additional funds on top of our Traditional 401K funds. The traditional 401K withdrawals should have a relatively low effective tax rate, and topping them up with Roth IRA funds should ensure our overall tax liability stays low. It also provides a small measure of tax diversification to have both in our portfolio.

    • Matt @ momanddadmoney January 6, 2014

      I 100% agree with you, which is why I put in the caveats about there being plenty of variables to consider other than this one. But I think that many people think that the evaluation is as simple as comparing marginal rates, assuming they’ll go up, and that’s that. My goal here was simply to show that that is not automatically the case. And even for people in your type situation where they’re already contributing to a 401(k) (not necessarily you specifically), a Traditional IRA still might make more sense. It might not, and there’s a good argument to be made for tax diversification as well, but I just hope that people make the evaluation properly. Thanks for the input!

  • Shannon January 6, 2014

    Wow Matt! What an informed and well-thought out argument for a Roth vs Traditional. And I agree with you, at the end of the day, the most important thing is that you have started some sort of savings vehicle for retirement.

    • Matt @ momanddadmoney January 6, 2014

      Thanks Shannon. And yep, starting is the most important step, no matter how you do it.

  • Grayson @ Debt Roundup January 6, 2014

    Great article Matt. I make this debate easy by just having two accounts. I can do so for right now, but soon might be out of the Roth due to income constraints. I will keep funding both until I can no longer.

    • Matt @ momanddadmoney January 6, 2014

      Doing a little of both certainly has its advantages. And the income constraints are certainly annoying, but in the end a good problem to have!

  • Stefanie @ brokeandbeau January 6, 2014

    Considering I make close to nothing now, I can’t imagine a traditional IRA being better for me than a ROTH, but I’ll have to do some calculations with this info. Thanks for sharing.

  • Raquel@PracticalCents January 6, 2014

    Nice analysis of the two retirement vehicles. Right now we have Roth Ira’s but I see how the traditional IRA is something to consider.

    • Matt @ momanddadmoney January 6, 2014

      Definitely worth running the numbers and knowing for sure. In the end the decision will be nothing more than an educated guess, but hopefully we can make it a little more educated and a little less guess!

  • Emily @ evolvingPF January 6, 2014

    Wonderful post, Matt, and not an argument I’ve seen made before. Great job explaining marginal vs. effective tax rates and I agree it’s an important consideration. I do have a few objections/caveats, which I’m sure can be covered in your “individual situations vary” disclaimer.

    I’ll echo what Done by Forty said about the likelihood of having multiple types of non-shiftable income in retirement that will fill up the lower tax brackets and cause the traditional IRA distributions to be taxes at or near the marginal tax rate instead of effective. I don’t agree with your assumption that SS will not exist (although I’m certainly trying to save as if it will not) and the pension aspect of course will vary with the individual’s job. My college roommate first job was actually pensioned, believe it or not! Another consideration here is that, given the assumption that the structure of our tax code will remain the same, that you do want to fill out your exemptions and deductions with taxable (traditional IRA) savings before tapping your Roth IRA to keep a 0% tax rate. That’s probably more optimization than is possible before the year of the distribution, though. All that to say, probably having a mix of taxable and non-taxable money available is best.

    Personally, I’m more concerned that your assumption that the tax code will be similar (which I agree is all we can do right now) will turn out to be wrong and that we will shift from heavily income-based taxation to heavily consumption-based taxation, which is an even stronger argument for deferring taxes.

    Thankfully (?), right now we’re in the 15% tax bracket, which is fairly universally considered Roth IRA territory even by those ravenous to defer taxes. When we start earning more, I think we will switch to a system similar to Mrs. Pop’s – a traditional 401(k) for most savings, and a Roth IRA for diversity. For our situation personally, we will likely be relying on IRA money in our retirement (at least as I see it now), so your argument about marginal vs. effective tax rates will largely apply to us and will also alleviate my concerns about consumption taxes.

    • Matt @ momanddadmoney January 6, 2014

      Emily, first of all, thank you for the incredibly thoughtful comments! You’ve really helped to elevate the discussion here.

      First of all, yes, depending on your assumptions about Social Security and a Pension the numbers will change. Or, if like DB40 suggested you do some part time work, the numbers will change as well. These are all important considerations when making your own personal decision. I will say that I’m not automatically assuming that Social Security won’t exist. Impossible for me to predict 35+ years out. I’m just recognizing that it’s not guaranteed.

      Second, on the subject of the tax code, like you say I’m not sure what else we can do. Sure you can assume that taxes will increase, but do we really know if that’s any more likely? Besides, contributing to a Traditional now actually gives us more flexibility later. If we pay the taxes now, they’re gone. It’s done. If we defer, then we have options. If taxes go down or we simply fall into a lower bracket because of behavior, great! Or maybe we have some low income years and choose to do a Roth conversion. The reality is that the tax code will absolutely change, but we don’t know how. I don’t think making assumptions is all that helpful or any more accurate. But understanding the potential implications in different scenarios is absolutely a valuable planning exercise so that you have contingencies in effect.

      Third, I can’t possibly give you any direct personal advice, but I would encourage you to look again at the example I give here. This couple is firmly in the 15% tax bracket and still comes out pretty far ahead with a Traditional IRA. Again, MANY variables to consider here and the Roth may absolutely be the right way to go, but I wouldn’t simply assume that the 15% tax bracket is Roth territory.

      Finally, I’ll just recognize that in the “individual situations may vary” disclaimer, that includes variables that may make a Roth more desirable as well as variables that may make a Traditional more desirable. It’s a much more complicated decision than this one example here, but my hope is that this example serves to illustrate that the truth is not as simple as it’s often made out to be by all the Roth proponents.

      Thanks again for the comments. Hope you have a wonderful week!

  • cashRebel January 6, 2014

    Great alternative viewpoint on a complex topic! I was trying to explain to a friend the other day that it totally depends whether or not to do roth or traditional. Most people just want simple rules, but it’s not simple. Though my friend has a pension, so the effective vs marginal tax bracket issues doesn’t really matter. But for those of us funding retirement with just our own assets, this really does matter.

    • Matt @ momanddadmoney January 6, 2014

      Thanks Ross! The rules are almost never as simple as we want them to be (though on a tangent, best investment practice may exception the exception where the answer is actually MORE simple than most people want it to be). Having a pension (lucky guy!) definitely changes the calculation though.

  • Josh January 6, 2014

    Matt, can you explain why IRA withdrawals are only taxed at the effective tax rate? That’s a little confusing to me/ not what I expected. Thank you so much for the analysis

    • Matt @ momanddadmoney January 6, 2014

      Sure Josh! This can be a little complicated to explain, but I’ll do my best.

      First of all, I just want to note that your income in retirement is taxed in exactly the same way as your income before retirement (in terms of Federal and State income taxes). If you simply think of your Traditional IRA withdrawals as essentially equivalent to your earned income today, it may be a littler simpler.

      Now, in the example in this article, I described a couple that is making $53,000 per year. That puts them right in the 15% tax bracket. But because we have a progessive tax code, not all of their income is taxed at 15%. Some of it is not taxed at all because of personal exemptions and the standard deduction. Some of it is only taxed at 10%. And only the last little bit is taxed at 15%. So even today, their effective tax rate, which is simply their total taxes paid divided by their total income, is less than 15%.

      The withdrawals from their Traditional IRA are treated the exact same way. Some of it is not taxed. Some is taxed at 10%, and some at 15%. So the last dollars are taxed at the marginal rate of 15%, but the withdrawal as a whole has an effective tax rate that is less than that.

      It’s important to note here that personal circumstances can change this calculation. As I note in the article, someone who has a pension and/or receives Social Security (or really any other source of income) will have that income taking up at least some of the lower tax brackets. So when you add the Traditional IRA withdrawals ON TOP of that other income, the effective rate on those withdrawals alone may be higher. It really all depends on the specific circumstances of the individual, which requires more personal evaluation than I’ve done here. But I wanted people to understand that the evaluation is more complex than is often presented, and that complexity MAY make a Traditional IRA more attractive than it’s often made out to be.

      Let me know if this answers your question, or if there’s anything else I can help explain. And of course, thanks for stopping by and participating in the conversation!

  • Shannon Ryan January 6, 2014

    Ah….the traditional versus Roth IRA debate. Excellent post, Matt. Like you said, the most important thing is to save for retirement. Both vehicles are good options. Roths certainly get more media play and at a high level do seem like the better bet, particularly for people just starting out and are most likely in the lowest tax brackets of their working career. As you noted, everybody’s’ circumstances are different so it’s hard to make a blanket statement that one is always superior. People also need to take into consideration how their other savings vehicles will be taxed as well. People so often forget to think about how taxes will affect their withdrawals and that needs to be considered as well. Ultimately, it may help guide them to the best IRA for their situation. My guess is knowing how detailed you are – that will be a future post! :)

    • Matt @ momanddadmoney January 6, 2014

      Thanks Shannon! I know you deal with this stuff all the time so I really appreciate your insight. I will say that I think it’s interesting that people automatically assume that young people are in the lowest tax bracket of their lives. For many people it’s true, but for many it’s not. As you know well, the tax brackets for single taxpayers progress much more quickly than for married couples, to go along with a lower standard deduction and, when kids enter the picture, fewer personal exemptions and tax credits. Then you add in the possibility of one person staying home with the kids and you have a very possible scenario in which you can make more money but have a lower tax rate later in your life. That’s exactly the situation my wife and I found ourselves in and I think it happens with a lot of people. We shouldn’t assume it will happen, but I don’t think it’s any more fair to automatically assume that we’re in a lower tax bracket when we start out. Maybe there are numbers on this that prove me wrong? If you know of any I’d love for you to share.

      In the end, I wholeheartedly agree with you that there’s no blanket answer that can apply to everyone. There are many factors that need to be considered and this is just one. But I think it’s one that’s often misunderstood, which is why I wanted to focus on it.

      And yes, there is a follow-up to this post that will be coming shortly. Stay tuned!

  • Andrew January 6, 2014

    Great article Matt. The Roth vs Traditional debate is something that I’ve always been interested in learning more about. It can get complicated and I don’t like the fact that everyone just argues that the Roth is the way to go. It really does depend. My father also told me to open an IRA when I started working…he told me to open the Roth. I didn’t pay attention and accidentally opened a traditional. Now I have both. Good points about the pension…I will have a pension so that will have to be taken into account so the Roth might be better for me. I do like the tax deduction from the Traditional though. Also, in the future, based on my wife and my salary, we might start running into the income limits for the Traditional IRA deduction. Can’t wait to read more about this topic.

    • Matt @ momanddadmoney January 6, 2014

      Man, you bring up a lot of good points! Just goes to show how much there is to consider here. As one of the lucky few who can still count on a pension, you definitely have to figure things differently. I’d be interested to hear how you’re doing it.

      • Andrew January 8, 2014

        I don’t really have a true strategy, and I haven’t gone into deeper analysis like you’ve done here in your post. But I contribute to a Traditional 401k (though a Roth 401k is an option). I make some contributions to my Roth IRA, but I should increase that. I figure there is some tax diversification there. While I do have a pension, I also live in NYC with high state and city taxes which shifts the balance back towards a Traditional. And as for non-mathematical reasoning…I’m rather take the tax savings now. I’m not overly worried about taxes in retirement…I’d like to think I’ve accumulated enough that I am comfortable. At that point, I won’t be paying FICA taxes, won’t be paying for commuting among other work related expenses, will hopefully have a paid off house or close to it and won’t be saving for retirement so I should be fine.

  • E.M. January 6, 2014

    This was an interesting article coupled with interesting comments! I have heard from others to not automatically assume that the Roth is best, even if you’re currently in a low tax bracket. Thanks for explaining it so well. I’ll have to look into the calculations.

    • Matt @ momanddadmoney January 6, 2014

      I know, aren’t the comments awesome! I feel very lucky to have so many smart and thoughtful people stop by and give their 2 cents. I’ve really enjoyed the conversation.

  • JoeTaxpayer January 6, 2014

    Interesting. But I believe the idea of using an average (or as you call it, effective) rate can be misleading. Looking at your chart, at a taxable $72,500, or $92,500 gross, the marginal rate is 15% I agree, and the effective rate is 10.79%. But when I go up $1000, even though you correctly show a 25% marginal rate, the effective rate is still just 10.94%.

    We agree that deductions are at the margin, but so are the withdrawals. Once I hit the 15/25 line, I’d wish I had some Roth or even regular post tax money I could access. Going 100% Roth certainly isn’t wise, as you’ve made clear that a gross $92K would cost less than $10K in tax to withdraw, so it’s good to ‘fill the lower brackets’ at retirement, but 100% pretax also misses the ideal mix, as a saver on a path to over $2.5M would have had better results with Roth deposits while in the 15% marginal rate.

    If I had to have a ‘rule of thumb’ I’d say that using Roth while at 15% or under and shifting to pretax for 25% or higher income is a good start.

    (Note – by positive selection, your readers are above average, still, if $2.5M feels too high a number, then using Roth for 10% income and pretax at 15% might be the mix. Either way, the long term goal is bracket smoothing.)

    • Matt @ momanddadmoney January 6, 2014

      Love it! Thanks for pointing out a really important point that I plan on addressing in a subsequent article, which is that the either/or choice is a false one. You can absolutely have both and the math you show here is an excellent example of why using both can be a really great strategy. I 100% agree with pretty much everything you say here, though I do think that trying to find the right line between tax brackets for switching over gets pretty murky with the uncertainty of future tax rates. That absolutely doesn’t mean it isn’t worth considering or using as part of your plan, just that precision isn’t really something you can realistically shoot for.

      But I don’t think that using the effective rate for withdrawals is misleading, just not 100% complete. The fact of the matter is that in most cases the contributon will be 100% at the margin while in many cases your withdrawal will only be partially at the margin. So the marginal rate in retirement is useful for the type of planning you describe here, where you try to fill up the lower brackets with a Traditional and use a Roth for the rest. And I agree that in an ideal world that’s how people should be trying to think. But in the real world a lot of people think in an either/or fashion and I was hoping to help them understand how that kind of comparison really needs to work.

      On a final note, I really appreciate you taking the time to provide this kind of excellent analysis here. This comment really adds a lot of value to the entire piece. Thank you.

  • Mike G January 6, 2014

    This isn’t real is it?
    First the contribution limit for a Roth IRA is the same as a Traditional one. You can add $11000 a year to either account. $11000 of after tax money or $11000 of pre-tax. Not $9350.
    You’ve also ignored the fact that any gains made in stock price or dividends payed out in this account is tax free with a Roth. On the other hand that money would have to taxed at a capital gains rate when you take it out of a Traditional IRA.

    This analysis is wrong and dangerously misleading.

    • Matt @ momanddadmoney January 6, 2014

      Hi Mike. Thanks for stopping by and adding your thoughts. I’ll try to address each of your points and would love to hear your response.

      First of all, you are of course correct that the maximum is the same for each. However, any real comparison we make has to be done with equivalent after-tax contributions, which is why I illustrated it in the way I did. If you would instead like to create a comparison using an $11,000 Roth IRA contribution, then the correct comparison would be to an $11,000 Traditional IRA contribution PLUS an investment of the tax savings from a Traditional IRA. If that extra investment is in a 401(k) or other tax-deferred account, then the logic and math here all stays the same. If other tax-deferred space is maxed out and that extra investment has to be made in a taxable account, then the math becomes more complicated and dependent on individual circumstances.

      Second, no I did not ignore the tax implications. In my illustration the Roth contributions grow 100% tax-free and are withdrawn 100% tax free. The Traditional contributions grow 100% tax-free and then are 100% subject to ordinary income tax (not capital gains) at withdrawal. The entire point of the comparison was to show that even with 100% of the withdrawals from a Traditional being taxed, you can still come out ahead because of the difference in marginal vs. effective tax rates.

      I 100% stand behind all of the math here. It is correct. I also 100% stand by the assertion that this information is not an answer for anyone, it’s simply information that can help people make a more informed decision. Any personal decision should include careful consideration of your own individual circumstances.

    • Emily @ evolvingPF January 7, 2014

      Matt answered a slightly different question, so I’ll supplement. Distributions from traditional IRAs are taxed as ordinary income, not at the capital gains rate. See header “Ordinary Income” here: http://www.irs.gov/publications/p17/ch17.html#en_US_2013_publink1000172748 So the comparison Matt provided here is valid.

  • Kim@Eyesonthedollar January 6, 2014

    Some great comments here, which is what I’ve come to expect from the PF community. However, the average person, unfortunately, has little understanding of tax or investment concepts, so I would say pick whichever and get started, which was a great first point in this post. I’m afraid people get too caught up in the language and fail to do anything, the worst possible choice!

    • Matt @ momanddadmoney January 8, 2014

      100% agree. I would much rather see someone simply get started with either than fail to do so because they got bogged down in the details. Contributions somewhere are always MUCH better than no contributions anywhere.

  • Brent Applegate January 7, 2014

    Helpful stuff. I look forward to a future analysis of 401K vs Roth IRA for those who can’t use the Traditional IRA due to income limits. THX!

    • Matt @ momanddadmoney January 8, 2014

      The same analysis would apply when comparing any Traditional account to any Roth account. There are other variables that can change, but in terms of the discussion in this article it’s the same.

  • Sam Dogen January 7, 2014

    401k max + IRA max = good idea.

    ROTH = thank you for supporting our government! We need more taxpayers!

    • Matt @ momanddadmoney January 8, 2014

      Haha. Well I don’t think it’s always quite so simple, but I think it’s much more true for a lot more people than is commonly assumed.

  • Student Debt Survivor January 7, 2014

    Save early, save often. I wish I’d started saving for retirement much much earlier. Those first years really make a big difference when it comes to compound interest (no matter which vehicle you use to save).

    • Matt @ momanddadmoney January 8, 2014

      Absolutely! Starting soon is definitely more important than getting this Traditional vs. Roth decision “right”. But still, a little bit of thought on it can make a big difference for people down the road.

  • Chaddogg January 7, 2014

    I think you’re missing a few other advantages/differences between the two that people should consider:

    1) Traditional IRAs/401ks are taxable upon inheritance, while Roth IRAs/Roth 401ks are not. This can have an impact if one of your goals is to leave a larger legacy, as it will be easier to do so with Roths arguably than Traditionals.

    2) Required minimum distributions – while Traditional IRAs/401ks are tax free when you contribute, the government wants its money eventually. One way they get it is to make you take required minimum distributions once you read age 70 (I believe). There’s a complex calculation here, but the result is you might be FORCED by RMDs to take out more money, thereby elevating you to a higher tax bracket than you otherwise might need/want to be in (i.e. if you only needed enough to stay in the 15% bracket to make ends meet at age 75, but your RMD number meant you had to take enough to be substantially in the 25% bracket, you’ve now been forced to take that money and pay the higher 25% tax amount on it.) Roths have no such RMDs.

    3) Access: while you should avoid at ALL costs touching your IRAs/401ks before retirement (seriously, don’t do it – you’re better off declaring bankruptcy, since creditors CANNOT get after IRA/401k funds), Roths have an advantage that you can withdraw, without penalty your CONTRIBUTIONS (i.e. the $5500 you put in, but not earnings) at anytime. No penalty, no tax. It makes Roths a nice kind of “last case scenario” emergency fund. Traditional 401ks/IRAs have large penalties put in if you try to access them.

    4) Inheritability: you’ll have to look around on where to do it (the Boglehead guide to investing talks about it), but there’s a way to set up your Roth to basically ensure your great-grandchildren will be billionaires, thanks to the inheritance provisions for the Roth. The same provisions do not apply to traditional IRAs/401ks.

    As for me, I have the good problem of being in a high enough tax bracket that maxing out my traditional 401k (and my wife’s, eventually) makes sense, since it’s unlikely that I’ll be in this high of a tax bracket for most/all of retirement. Indeed, if I contributed to a traditional IRA I would get no tax advantage from doing so (although it would grow tax free)….so a taxable account is, in some ways (namely flexibility of use, ability to access earlier without penalty, etc.) preferable after the 401ks are maxed out, rather than contributing more towards “retirement” accounts.

    • Matt @ momanddadmoney January 8, 2014

      First of all, thank you for the incredibly valuable contribution to the conversation here. These are some great points.

      I’ll say that my only point with this post was to point out the inherent flaw in how people compare the tax benefits of one vs. the other, which is why none of these points are addressed here. But the arguments you make here are absolutely relevant to the final decision and would fall into my “many other variables” disclaimers in the article. Some of them are also points that are already planned for future follow-up posts, but I’ll give some quick responses here as well.

      1) Yes, you are correct. If leaving an estate is important to you than a Roth can be a very valuable tool. But that doesn’t necessarily mean you have to contribute to it directly. As of now we have the option to convert to a Roth at any time, which means you could choose to do so in years where it was more tax-advantageous for you to do so, rather than forcing yourself into whatever tax situation you’re in right now.

      2) Yes, RMDs are definitely a concern. But you would still need to consider the relative taxes of the Traditional withdrawals vs. the Roth contributions. Hard to do with such uncertainty about tax rates, RMD rules and so forth decades down the road. So while the Roth would give you some nice flexibility here, it shouldn’t simply be assumed to be an automatic win. And again, just as in #1 you could convert to a Roth down the line when it’s convenient for you rather than assuming you have to make the contribution today.

      3) Yes, access is definitely a “benefit” of the Roth. I put it in quotes because I agree that it’s nice to have options, but I would rather help someone plan to have those options elsewhere and never touch their retirement funds. But yes, the flexibility CAN be useful.

      4) Not sure about ensuring your great-grandchildren will be billionaires, especially since you can’t put life insurance inside an IRA. If you can find an explanation of this I’d love to hear it, as I can’t off the top of my head fathom how this would be done unless you simply get lucky by picking an explosive growth stock, which could of course be done in any type of account.

      With all of this said, it’s clear that an individual’s decision needs a more nuanced analysis. Thanks for highlighting some important things to keep in mind.

  • MoneySmartGuides January 7, 2014

    Wow great explanation! I too was told ROTH ROTH ROTH when I was young and looking for advise on where to start with my retirement. Good analysis.

    • Matt @ momanddadmoney January 8, 2014

      It seems to be pretty ubiquitous. I mean, a Roth can be a great tool for people. I just want people to understand the more nuanced reality rather than relying 100% on simplified rules of thumb.

  • Holly Johnson January 8, 2014

    Great insight. We do both because we don’t know what will happen in the future and because we’re able to sock away quite a bit. Both my SEP IRA and Roth IRA are safely with Vanguard =)

  • Laurie @thefrugalfarmer January 8, 2014

    So, for us, Matt, as a middle aged couple with lots of deductions right now, we pay next to nothing in taxes. Which type of IRA would you suggest for us?

    • Matt @ momanddadmoney January 8, 2014

      To be perfectly honest, I really can’t give you any specific personal advice. There are too many variables I don’t know that would make such advice inappropriate. But I will say that as a general principle, tax deferral is only useful to the extent that you actually have taxes to defer. For someone who doesn’t currently owe taxes there’s really no value in a current deduction.

  • Tonya January 8, 2014

    Thanks for all the info Matt. I vowed to get more educated on the various retirement accounts this year…something I’ve neglected to know more about in the past. It’s time. :)

    • Matt @ momanddadmoney January 8, 2014

      Well with all the cool stuff you’ve got going on, it definitely seems like this could be the year to make it happen. Good luck!

  • Kyle James January 8, 2014

    Excellent comparison. I always considered, and was often told, that the Roth IRA was better as you didn’t have to pay taxes in the future when you take money out of it. Clearly I was not looking at the whole picture.

    • Matt @ momanddadmoney January 8, 2014

      There are certainly situations where the Roth is a better choice. This is only part of the picture but it’s part that I think is widely misunderstood.

  • Roger Wohlner January 8, 2014

    Great post. There is so much “love” for the Roth IRA route out there it is refreshing to see someone actually crunch the numbers. You are correct that there is no right answer and in fact the answer will differ from investor to investor. I liked your approach and would add one other factor to consider, that being the time value of money specifically on the amount of tax savings from using a deductible Traditional IRA. While the money from the Roth can be withdrawn tax free at some point in the future, a dollar of tax deferral today may be worth more than a dollar of tax savings 20-30 years down the road for younger investors. Again no right answer here one needs to run the numbers and not take the word of the financial press or the financial services firms for this.

    • Matt @ momanddadmoney January 9, 2014

      Thanks Roger! Means a lot coming from you. Would you mind explaining a little more, or pointing towards an article, what you mean by the tax savings being worth more later than it is today? I mean, I get how that might be true based on the tax rates applied (as is obviously the point of this article), but I’m not exactly sure what you mean beyond that. I’ve always thought that if tax rates were truly equal, then it makes no difference whether you pay them now or pay them later, but I would love to learn something new. Thanks!

      • Roger Wohlner January 9, 2014

        Matt all I was saying is that the tax deferral today and in subsequent years will generate positive cash flow for the Traditional IRA investor in terms of savings on their income taxes. This cash flow needs to be compared to impact of expected taxes to be paid down the road during the withdrawal phase. Likewise the reverse calculation needs to be made with the taxes paid upfront during accumulation for the Roth vs the tax savings in the withdrawal phase. Assumptions need to be made in both cases obviously. Further these cash flows need to be discounted to the present via a time value of money calculation and compared. Again a discount rate assumption is needed and perhaps a comparison at various discount rates is appropriate. As you know dollars earned (or not spent on taxes) in the present are worth more than dollars saved on taxes 20-30 or more years out. My point was that the impact of the time value of money should be considered. An investor could conceivably invest the dollars saved in taxes via the Traditional IRA and the return on that money should be considered.

        • Matt @ momanddadmoney January 9, 2014

          Ahh, I see what you mean. Yes you are 100% percent correct and I completely agree. That’s exactly why it’s important to understand that it’s inappropriate to compare maxing out the Roth to maxing out the Traditional. If that’s all you do, then yes the Roth will win. But as you say, the tax savings on the Traditional can be additionally invested. Now, whether people will actually DO that is another question altogether.

          Thanks for the explanation!

  • BrokeMillennial January 9, 2014

    This does indeed help me make a more informed decision. I have a Roth 401k and I’m currently toying with the idea of also doing an IRA. Perhaps I’ll do traditional — plus I could run a fun comparison of how they turned out in 35 years when I’m 59.5!

  • Matt May 23, 2014

    The issue I have with this analysis is that advocating for a traditional IRA for tax savings doesn’t account for the growth of the money in the account. If you invest at $5,500/year for 30 years in a Roth IRA, you will pay taxes on $165,000 of income. This money will compound for those 30 years and be forever tax-free. In a Traditional IRA, that $165,000 is tax-deferred, but if you live long enough to withdraw most of it, you’ll be taxed on what will likely have grown to somewhere in the neighborhood of $1 million. At 15%, that $165,000 Roth contribution will cost $24,750. If you eventually withdraw all of your funds from the Traditional IRA, even at 10% you are paying $100,000 in taxes. In light of this math, how do you justify the Traditional option to a financial imbecile (like me)?

    • Matt Becker May 23, 2014

      Hi Matt. Thanks for the comment! Now, for your answer…

      If you contribute equivalent after tax amounts to both accounts, and your tax rate is the same at the time of contribution as it is at the time of withdrawal, then it won’t make a difference which one you use. The fact that your taxed on a higher dollar amount for a Traditional is actually irrelevant.

      Here’s a very simple example. Let’s say that you’re in the 25% tax bracket today and in retirement. Now let’s say you have $1,000 pre-tax that you can invest and that it will earn an 8% return

      If you contribute to a Traditional IRA, you can invest the entire $1,000 (because it’s not taxed). Over 30 years that $1,000 will grow to $10,063. But when you withdraw it, it will be taxed at 25%, so you will only be able to withdraw $7,547.

      If you instead go with a Roth IRA, the equivalent after-tax contribution would only be $750 because you had to pay the $250 in taxes. Over 30 years that $750 will grow to $7,547, the exact same as the after-tax value of the Traditional route. So you can see that the growth within the account makes no difference.

      Now, if you’re comparing a $5,500 per year contribution to a Roth to a $5,500 per year contribution to a Traditional, then yes you’re correct that the Roth will come out ahead. I mention that here: 5 Reasons a Roth IRA Might be Right for You. But that’s because you essentially contributed more to the Roth (on an after-tax basis).

      I hope this helps answer your question. If you want any more explanation please let me know. I’m always happy to continue the conversation!

    • Matt Becker May 23, 2014

      Here’s another article that helps explain why the after-tax amount works out to the same either way, all else being equal. Hope it helps: http://thefinancebuff.com/commutative-law-of-multiplication.html.

I’d love to hear from you, please leave a comment