Choosing The Best IRA For Your Needs: Traditional Or Roth
There are five different types of IRAs: the Traditional IRA, Roth IRA, Simple IRA, SEP IRA, and Education IRA. This article focuses on the first two, Traditional and Roth, because the other variations are appropriate only for a small subset of investors.
An IRA, or Individual Retirement Account, is simply a tax-advantaged account for retirement savings. First, let’s find out what they have in common.
Common Attributes
- $5,000 Contribution Limit ($6,000 for those 50 or above) (2009)
- Phase-out range of $105,000-$120,000 for single filers (2009)
- Phase-out range of $166,000-$176,000 for married filing jointly filers (2009)
- 10% early-withdrawal penalty if withdrawn before 59 1/2 years old (with a few hardship exceptions)
- Tax-free compounding
Traditional IRA-Specific Attributes
- Tax-deductible in the current year, just like a 401k
- 100% taxable as regular income upon withdrawal
- Required Minimum Distributions (RMD) once you reach age 70, based on your life expectancy (suspended for 2009, but applicable in future years)
Roth IRA-Specific Attributes
- Not tax-deductible in the current year, i.e. you contribute with after-tax dollars
- Earnings and contributions are 100% tax-free upon withdrawal after age 59 1/2
- No Required Minimum Distributions (RMD)
Which Is The Best IRA For You?
From a theoretical standpoint, the best IRA for your circumstances depends on your tax situation: if you expect to be in a higher tax bracket when you retire (or expect tax rates to go up generally), you’re better off paying taxes now using a Roth IRA. If, on the other hand, you expect your tax rate in retirement to go down, you’re better off deferring taxes until then using a Traditional IRA.
Of course, in the real world nobody knows for sure what tax rates will be in 20, 30, or 40 years. My bet would be on higher taxes to pay the massive national debt we’ve accumulated, but that’s not a sure thing. Hence, I think most people would be wise to hedge their bets, contributing to both a tax-deferred retirement plan such as a Traditional IRA or 401k and a tax-free plan like a Roth IRA or Roth 401k. Conventional wisdom holds that you should invest in the following accounts in this order:
- 401k up to the company match
- Roth IRA (if eligible)
- 401k or Traditional IRA
- Non-Deductible IRA
- Taxable Account
Of course, your mileage may vary.
Once you’ve decided which type of account (or accounts) to go with, check out my post on which mutual fund company best deserves your retirement dollars.
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Excellent article. Thanks for explaining the differences. The primary hesitation that I have with all of these plans is that I cannot get my money for 30+ years. That is not acceptable.
This article sums it up nicely. I would add that you should first invest in your 401k up to the company match, then max out the Roth IRA, and then, if there’s any money left, contribute more to the 401k or traditional IRA.
@Curt – if you have some money you can save away for 30+ years, it goes a long way in funding your retirement. There’s plenty of articles on the web that explain that in more detail – probably even one on this blog.
David, good call on the 401k up to the company match. I updated the post.
Great summary, Kyle. This will be the first year that we’ll contribute to both 401k and Roth IRA. I agree with your final order of things. At least that’s logically what works for us.
I just have one question. The company that I work for has an excellent amount of options for the Roth/Traditional 401k. They match 50% of 8%, so a max of 4%. So far, I don’t see the point of getting an IRA when I have plenty of options with my 401k. I am currently able to contribute 17% of my income to a Roth 401k, but would I benefit from only taking up to the company match and then opening an IRA for the rest? I also like the simplicity I have now with it all being in one place. So far, most people seem to choose an IRA because it has more diverse funds, but I don’t seem to have that problem.
Maybe in another article you could talk about reasons to choose a 401k vs an IRA, and their differences.
Good summary…I’m hoping to branch out into #2 this year.
I’m already investing in my company’s roth 401K, which has the benefit of built in diversification. My contributions go in as a Roth, whereas their match is traditional.
@ Sky – I think one thing you may want to consider if that there are much stricter income limits on an IRA than there is a 401K.
I could be mistaken, but I think there is no income limit on a 401K, just a contribution limit of $16,500.
However, with the IRA, there is an income limit ($166,000 – $176,000), as well as a much lower contribution limit ($5000).
That’s why the traditional logic says only invest in a 401K to get the match, then go to outside IRAs.
If your income goes up, you may lose the ability to contribute at all to an IRA. However, you can always put more money in a 401K later.