Investing in a Roth IRA vs. Traditional IRA
This has been one of the hardest questions to answer for me personally with our finances so I thought it'd be a great topic for conversation. My wife and I don't make enough combined to be limited on whether we can invest or not in the Roth so this question is even more interesting for us to consider. First off, many people will lead you to believe that there is a major difference or an easy answer. That's not usually the case. There is actually lots to consider because what you are hedging against is the idea that you are paying less in taxes now or paying more in taxes later. The problem with that is no one knows what you'll have to pay in taxes in the future. So what do you do? Here is what I recommend.
"With a few exceptions, I always invest in a tax deferred account before a Roth because the extra compound interest over 30 to 35 years will build more wealth than the taxes I will have to pay when I take it out."
Much like Financial Samurai posted in his blog post, I believe some of the benefits of the Roth can be overblown. However, the Roth is a great option under certain situations. Much like anything in life, it's not black and white. And hey while we're at it, let me throw out a disclaimer. I used to worry about this quite a bit before I realized it's actually pretty hard to mess up with this question. It will not make or break your financial well being. Don't stress too much either way! If you want to know what I do, I have chosen to contribute to a Roth in some years and not in other years depending on my upcoming goals and my families joint income for the year.
Here is when it is a good idea to invest in Roth IRA's and Roth 401k's:
1) You will be a first-time homebuyer in the next 5 or more years: If you want to potentially use your Roth IRA money to help purchase your home it can be a great boost to your savings.
2) You fall into a low tax bracket with your earned income. Look at your tax brackets. If you realize that you will be paying 15% or less on the money you invest in the Roth. I'd say go ahead and chose the Roth. For example, if your tax situation is married filing jointly in 2017 you only have to pay 15% income tax for all your earned income under $75,900. So we contribute to a Roth with any income below that we don't spend that falls into that level. However, we first focus on making sure we are in that tax bracket by maximizing our tax-deferred options with our 401k, traditional IRA, and HSA contributions. I know you will hear different advice and feel free to choose what you feel comfortable with. But following that has worked out great for us! Disclaimer: I was told by a financial planner to contribute everything into a Roth through my work Roth 401k option because I can. But I disagree. I think you have to look beyond the basic 'Roth IRA is better than tax-deferred' logic. You have to consider your circumstances. For me, I'd rather guarantee I don't pay 25% taxes on my income now in hopes to pay fewer taxes later. Maybe I'll pay more taxes later or maybe I won't, no one knows, but I can guarantee that paying 25% income tax is not a great as 15% and I want to limit my taxes now while I can.
3) You want to retire early. This one can get complicated. But generally speaking, it's a good idea to contribute something to a Roth in your working years if you hope to retire early because you can pull out your contributions anytime. It can also be a great way to build a Roth IRA conversion ladder, or just have some funds to live off of until you're retirement accounts are accessible.
4) You think your Required Minimum Distributions (RMD's) will put you into a higher tax bracket. From my research, this is rare. Specifically, if you are able to contribute to a Roth at a young age because that often means you aren't earning as much. If you save a great deal of your income and plan to continue to work until at least 65, a Roth might be a good if you think your RMD will put you into a much higher tax bracket at that time.
When to invest in traditional IRA's and traditional 401k's:
1) Your income falls into a higher tax bracket: You can save more with traditional IRA and 401k's. Going back to the same example as before I will always invest in a tax-deferred account if I am paying over 25% in income tax. The reason being I can guarantee I pay less in taxes now in hopes that I can also withdraw that money later with fewer taxes.
2) Compound Interest: Many times people try to compare the Roth to a traditional IRA with the same amount of contributions. You have to also consider how much less you can contribute when you are taxed before it goes into your investment account vs not paying taxes now. You can build your foundation faster and allow your investments to compound faster when you have more money. That is why I always invest in a tax-deferred account before a Roth with all funds that fall outside the 15% tax bracket. The reason being, the math proves the compound interest over 30 to 35 years on the extra money I can contribute will build more wealth over time than the taxes I will have to pay off my distributions from those investments.
For example, investing 75k vs 100k (the difference at the 25% tax bracket) into a Roth vs Traditional IRA will result in $1,478,534 vs $1,108,900 in 35 years at 8% interest. That's a difference of $370,000. So the difference is still actually 25% but I am betting that I can withdraw that difference at a lower tax bracket than paying 25% on all of these additional earnings. The reason being is that you won't be taxed on it all once, only what you withdraw for income. So inflation adjusted back to today at 3% that's a $131,491 difference. Personally, I won't need that much in income per year. Even if I did, the first 75k would only be taxed at 15% or less given my tax bracket this year.
3) You plan to convert it to a Roth later while living on a lower income: Current tax laws say you can convert your traditional IRA funds into a Roth at any time. My stance on this sort of investment decision is you can always try to figure out a way later to convert to a Roth if it makes sense for you. You can always work with a tax professional later or develop your own plan that during low-income years (whenever that may be) before age 70 1/2 you can convert your traditional IRA payments into Roth contributions and take those contributions out 5 years later with no additional tax.
4) You think your lifestyle will be less expensive than your working years: Most people argue the Roth is so good because you are in a low-income tax bracket now. Well, why wouldn't you be in a lower tax bracket in retirement than when you were working? For some they may plan to continue or expand their spending, but I'd guess that most people will spend less in retirement per year than they do during the years they are raising a family, paying off debt, etc. Unless retirements your retirement plan is to a lot more money and go traveling around the globe at the age of 65 or older, I'd say take the tax savings now because you likely won't be spending that much later in your retirement years.