ROTH versus Traditional

I get asked a lot about whether people should put their money into a ROTH IRA or a Traditional. It is always a tough question and usually the answer is “it depends”. But I thought I would lay out a little quick “rule of thumb”. First a quick refresher:

A ROTH IRA (or 401(k)) means that you don’t get a deduction when you put money in, money grows tax-free and when withdrawn (assuming a few restrictions are met) there is not tax.

A Traditional IRA (or 401(k)) means that you get a deduction now when you put money in, money grows tax-deferred and you pay ordinary income on the withdrawals when you take them out.

As you can see from the table, the general idea is that, if you think your taxes will be higher later, a ROTH will give you a better benefit.

If you think taxes will be higher now and lower later, than a Traditional is typically better.

A couple caveats to this:

It assumes that you only have $5,000 total – which means that you only have $3,500 to put into the ROTH IRA since you have to pay taxes on the $5,000. This is very infrequently the case – most people get to tax time and have $5,000 to put into an IRA. They will simple get a slightly refund if they put it into the traditional. This will tilt the math towards the Traditional.

This also assumes that the money you save in taxes you invest. Again, this isn’t always true – if you owe a little less or get a slighter larger refund it is very commonly just spent – which means you don’t get any additional benefit from having that additional money compounding and earning money. This also tends to tilt the decision towards a Traditional.

Under both of these scenarios you might be better off with a ROTH since a full $5,000 compounding tax free will be better than $5,000 you have to pay tax on later. Click through to the Spreadsheet and see different examples. You’ll see one tab for Higher Taxes Now, one for Lower Taxes Now and one for Tax Savings Spent, Not Saved. These can help get an idea of what you should do.

Hope this helps!