Roth vs. Traditional IRA Decision: Which One Will Maximize Your Money?

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As an investor, your goal is to invest in a way that gives you the highest after-tax return on your money.

You can do that in one of two ways:

1. Asset Allocation: The types of investments you choose — stocks, bonds, cash, mutual funds, and so on.
2. Asset Location: The types of accounts you invest in — traditional or Roth IRA, 401(K), taxable account, and so on.

Choosing between a traditional and Roth IRA is a choice of asset location.

Neither type of IRA is better than the other. It’s your individual financial situation that determines which type of account will optimize your after-tax returns.

One common piece of advice you’ll find online for this topic is something to the effect of: If your tax bracket will be higher now than in retirement, invest in a traditional IRA.

That can be good advice. But to get the right answer, there’s a lot more you need to know.

And it’s important to take the time to make sure you’re fully informed, because this is an important decision. Choosing the right account today can have a sizable impact on your future retirement savings.

In this article, we’ll go over:

• The difference between Roth and traditional IRAs.
• Knowing your marginal tax rate (and why it matters).
• Understanding the impact of IRA required minimum distributions.
• The difference in Roth and traditional IRA contribution limits.
• General guidelines for who should choose a Roth IRA.
• General guidelines for who should choose a traditional IRA.
• General guidelines for investing in both a traditional and Roth IRA.

Part #1: Which IRA Is Best For You?

The primary difference between a traditional and Roth IRA is the taxation benefits.

• Traditional IRA: Contributions are tax-deductible, and taxes are deferred until withdrawn.
• Roth IRA: Contributions are not deductible, but withdrawals are tax-free.

But that’s just the beginning.

Here’s what else you need to know, which may impact your decision.

Section Notes:

• What is a qualified withdrawal? If you’re over the age of 59½, you may withdraw any amount from a traditional IRA penalty-free. You can withdraw from a Roth IRA penalty-free after the age of 59½, as long as the account has been open for five years.

Factor #1: Marginal Tax Rate vs. Tax Bracket

When it comes to choosing the right IRA, the most important step is comparing your current and future tax rates.

Your goal is to pay taxes at the lowest possible rate.

That’s why you’ll often hear the following advice:

• If your tax rates today are lower than they will be at the time of withdrawal, choose a Roth IRA.
• If your tax rates today are higher than they will be at the time of withdrawal, choose a traditional IRA.

And this is true. But there’s one mistake that’s all too common.

To understand what you’re taxed today, you have to know your marginal tax rate, which is the tax rate applied to the next $1 of income.

For example, say your federal tax bracket is 25% and your state tax bracket is 5%. (By the way, forgetting to include state taxes is another common mistake.)

To keep this example simple, let’s assume you take the standard deduction and are not affected by any credits, phaseouts, etc.

In this scenario, an extra $1 of income would have a marginal tax rate of 30%.

The easiest way to understand your marginal tax rate is to use tax software. (You don’t have to buy the software unless you use it to file.)

With software, you can add $1,000 to your income and see the impact. If you’re considering investing in a traditional IRA, deduct $1,000 to measure the impact.

It can be more complicated once you add income phaseouts, credits, and so forth. But taking the step above will give you a close estimate of your marginal tax rate.

Section Notes:

• You lose a lot of tax credits as you retire, so you don’t want to over save in tax-deferred accounts.
• If you plan to pass on your IRA, you must factor in the marginal tax rate of the beneficiary. You want to look at your current marginal tax rate compared to the expected marginal tax rate of the beneficiary.

Factor #2: IRA Required Minimum Distributions

Comparing current and future marginal tax rates is the primary factor in choosing the IRA with the highest after-tax return.

Unfortunately, income taxes are not the only taxes associated with an IRA account.

Traditional IRAs are subject to required minimum distributions (RMDs).

Roth IRA accounts do not have RMDs.

RMDs are a part of tax law that requires you to withdraw a certain amount of your traditional IRA each year, beginning at age 70½.

This is a disadvantage for those who:

• Plan to work past the age of 70, and who will thus maintain a higher tax bracket.
• Who want to pass on their IRA to a beneficiary.

Factor #3: The Difference in Roth and Traditional IRA Contribution Limits

In 2022, Roth and traditional IRAs have the same maximum contribution limits.

You can contribute:

• Traditional: $6,00, or $7,000 if age 50 or older.
• Roth: $6,00, or $7,000 if age 50 or older.

What’s important to understand is that $6,000 in a Roth IRA isn’t equal to $6,000 in a traditional IRA.

In a traditional IRA, part of your account belongs to the IRS.

If you expect to pay 15% tax on your withdrawals, 15% belongs to the IRS.

With a Roth IRA, 100% is yours to keep.

So the contribution limit is higher for Roth IRAs.

This comes into play for those wanting to max out their IRAs but still have money in taxable investment accounts. All things being equal, it’s better to invest 100% in a Roth IRA than (for example) 85% in a traditional IRA and 15% in a taxable account.

This is another advantage for Roth IRAs.

Related Reading: If you’ve maxed out your contributions, you should also consider using a Health Savings Account, which offers an opportunity for $3,500 per year in additional tax-advantaged saving and investing. You can read more about HSAs in my detailed review of Lively, a no-fee HSA provider.

Part #2: Guidelines for Choosing a Roth or Traditional IRA

The factors that determine which account will provide the highest after-tax return are:

1. Current vs. future marginal tax rates.
2. The impact of RMDs.
3. If you’re maxing out contributions in all tax-deferred accounts, leaving you only taxable accounts to invest in.

With this in mind, let’s look at some general guidelines for choosing an IRA.

General Guidelines For Investing in a Roth IRA

When does paying taxes now, via investing in a Roth IRA, make more sense than deferring taxes?

Let’s look at a few common scenarios:

• If your current marginal tax rate is 15% or less.
• If you expect to have a higher marginal tax rate in the future.
• If you expect to have the same or higher marginal tax rate as you do now after the age of 70½.
• If you’re maxing out contributions in all available tax-deferred accounts, leaving you only taxable accounts to invest in.

Beginning Investing Tip

One benefit to a Roth IRA is that you’re able to withdrawal contributions any time without taxes or penalty. So, if you’re hesitant to start investing because you’re afraid you’re going to need the cash and don’t want to tie it up, Roth IRAs offer more short-term flexibility.

In a sense, they can act as a secondary emergency fund (which you hopefully don’t have to use) that can provide a bit of peace of mind when you’re just starting out.

General Guidelines for Choosing a Traditional IRA

When does deferring tax, via investing in a traditional IRA, make more sense?

When you expect your tax rate (or the tax rate of the beneficiary) to be lower at the time of withdrawal or rollover.

While we’ve covered the former, one option available to you when you invest in a traditional IRA is rolling over your traditional into a Roth IRA.

When you do this, you’ll have to pay taxes on the amount you roll over. However, if your tax rate happens to be lower for just one year in the future, you can come out ahead.

As an example, let’s say you’re a business owner in the 33% tax bracket who plans to sell their business in the near future.

The year after selling your business, you plan to take some time before figuring out what to do next. Therefore, you expect your income and tax bracket to be in the 15% range rather than the 33% range.

In this example, it can make sense to invest in a traditional IRA when you’re in the 33% tax bracket. The year after you sell your business (when you find yourself in a lower tax bracket), you can roll over that amount to a Roth IRA.

Another common example is someone who plans on moving from a state with a high income tax to a state with no income tax. In that case, they’d invest in a traditional IRA today and then roll that amount over upon taking up residency in the tax-free state.

General Guidelines for Choosing Split Contributions

The further you are away from withdrawing from your IRA, the harder it is to predict your future tax rate.

It’s hard to predict what your life will be like in the future, and it’s impossible to predict what the government will do.

Here are just some possibilities:

• Federal and state tax rates may increase.
• Roth IRAs may lose some of their benefits.
• Estate taxes may change.
• Social Security income may change.

You get the idea.

There’s no shortage of variables that are outside of your control.

That’s why it may make sense to invest in both a Roth and traditional IRA.

You’re allowed to split your contributions between both, and by doing so, you’re essentially hedging your tax situation. This makes sense for those for whom it’s very difficult to predict their future tax situation.