Before we go further, let's make an important point. Most people, including many financial advisers, are unaware of this, but if the money going into your Roth IRA is taxed at the same rate as the money coming out of your traditional IRA, then you will have the exact same amount of money after taxes with both account types. For the sake of simplicity, I won't get into the math, but it's true. You can listen to the podcast below to verify this.
Consider a couple who are married filing jointly with a taxable income of $90,000. In 2016, this places them in the 25% marginal tax bracket. If they each contribute $5,500 to traditional IRAs for a total of $11,000, this will save them $2,750 of federal income tax this year, money which could (and should) be saved in an employer retirement plan (e.g. 401k, 403b) or a taxable account (more on that below). By contrast, if they contributed $11,000 to a Roth IRA, there would be no immediate tax savings.
After reaching age 59.5, this couple could begin taking standard withdrawals from their IRAs with no penalty (note that there are several methods whereby these funds can be accessed before this age with no penalty but the money is still taxed). Withdrawals from the Roth IRA are tax free, but withdrawals from the traditional IRA are taxed as earned income.
Let's say that after they retire, they still have the same living expenses, so they would need $90,000 per year from their traditional IRA. They would owe $11,905 of federal income taxes on that money. Yes, their marginal tax rate would still be 25%, but, more importantly, their effective tax rate (total taxes divided by their income) would only be 13.2%. Why? Because most of their retirement income would be taxed at the two brackets lower than 25%. So in reality, they will pay only 13.2% federal income taxes on their retirement income (25% - 11.8%), whereas all of the money going into their Roth IRA was taxed at 25%.
To put it another way, which would you prefer, to pay 25% tax on the money going into your piggy bank or 13.2% on the money you take out?
Someone might point out that if this couple could max out both retirement accounts that the Roth IRA would, effectively, have a higher balance going into retirement because all of its assets would be tax free. This is true, but it's at the expense of more money through more taxes paid on the front end. And if our couple was wise and took the savings from the traditional IRA and invested it each year into a savvy investment like an index fund with very low turnover (meaning very low taxes) or something like Berkshire Hathaway stock that pays no dividends (meaning no income taxes on gains until sold) and held it until retirement, when the gains are taxed at the much lower capital gains tax rates, which could easily be zero in this situation, using the traditional IRA would still be far superior.
The Roth IRA will result in fewer tax dollars paid, but we're not just trying to minimize tax dollars paid; we want the most after tax money available in retirement. When all the chips are on the table, our hypothetical couple will have more money in retirement with the traditional IRA. There's a big assumption here, though, which I address below.
If tax rates increase significantly between the time that the couple made the contributions to their IRAs and the time they withdraw them, then the Roth IRA might be preferable financially. But how much would they have to increase for this to occur? A lot! The traditional IRA results in a 13.2% effective tax rate in this situation, while the Roth IRA results in a 25% effective tax rate. So the total federal income tax (in terms of dollars) on a $90,000 annual income would need to nearly double to make the Roth IRA preferable in this situation. That seems like an awfully big gamble to me.
The major reason that the traditional IRA wins in this situation is because the couple is in the 25% marginal tax bracket during their working years, meaning that their Roth contributions are effectively taxed at that rate. If their income was low enough that they were in the 15% bracket, most, though not all, of the advantage of the traditional IRA would go away. It is for this reason that some financial advisers recommend that people in the bottom two income tax brackets contribute to the Roth IRA (usually on the assumption that the couples' income and tax brackets will increase later in their lives), but those in higher brackets should contribute to the traditional IRA.
Be aware that state income taxes can also change this situation. For instance, if you live in a state with no income tax like Washington during your working years but then retire to a state with high income tax like California, the Roth might be superior. If the situation were reversed, the traditional IRA would gain an even bigger advantage over the Roth.
There is another way that contributing to a traditional IRA is superior, and it's a strategy called Roth laddering. I won't get into all of the details but just want to mention it to those potentially interested, especially in early retirement.
I'm sure I've opened up a can of worms here, so let's see what everyone else thinks of all this!
Disclaimer: I am not a certified financial planner, and I am not offering investment or tax advice. The above scenarios are hypothetical only. You should consult a professional before making any investment or tax decisions.
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Why a traditional IRA often makes more sense than a Roth IRA
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