“I just read an article about Roth IRA and Traditional. It was good, but… I still don’t know which is better for me”
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Question: Why do we need another article on this topic? There are a million!
Good point. I’d like to attempt to save you some time here. Please look up “Roth vs Traditional IRA” and read whatever article looks appealing. If you know which is better for you, no need to read this article.
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Back? Yup, OK. Thought so.
Now you know why we need another article.
Because I’m putting this debate to rest once and for all.
But first, a rant!
As you probably saw, many who take on this topic provide a bunch of data ABOUT the accounts, skirting around actually answering the question and providing understanding. While the account details are important factors to consider in your decision, I believe the fundamentals are more important to understand first.
When deciding between buying an SUV and a sportscar, the gas tank size isn’t the first piece of information you go looking for.
I searched “Roth vs Traditional IRA” and Nerdwallet has the featured article. I clicked on it, and almost thought I didn’t have to write this post.
Ok. Super simple right? Off to a good start.
Makes sense. It’s based what tax rate you will have in the future. No idea what that will be though, because we do not know what the future will bring.
Hm. Read my mind. Good things there are other ways to decide.
Wait. What? The IRS rules on eligibility may decide for me? I thought the decision was based on my future tax rate. Now it’s saying it’s based on my current eligibility? Do I still have to think about the future?
Well that makes it a lot easier actually. I just have to study the table to see which account I can contribute to….
Well, looks like the traditional IRA it is because I make too much to qualify for a Roth contribution. Won’t get any deduction though, darn. But, pretty easy I suppose.
The heck is going on here?
This is why we need another article on this topic.
Four reasons that I can think of:
1) When people bring in all this technical information to start off the comparison, you can see how confusing it gets. I myself got confused reading through the article, and I’ve been studying this stuff since 2014.
2) All this technical details makes us feel like we’re getting educated, but it’s really just distracting us from answering first question we set out to answer, and we may end up making a decision without answering that question. What was that again?
3) As you saw with that backdoor Roth IRA twist, the technical details may not even freakin’ matter! Let’s say you decide that the Roth IRA is the best option for you, but you make too much to qualify. You can still get money into a Roth IRA. That’s where the details come into play based on the very nature of the task.
Now, just because you can, it doesn’t mean it’s the best choice. This is called availability bias. When we want to answer a question, but the most important data is not available (in this case, knowledge of future tax rates), we place a disproportionately high importance on the data we do have available, even if it’s useless.
4) Personally, I think this one is the worst one: when people DO make a decision for you. They often inject their own opinions into the evidence they use to back up their conclusions.
For example, some people who say Roth IRAs are better will say, “Taxes are BOUND to go up in the future. Who wouldn’t agree? Look how low they are now! Look how high the national debt is. What a mess! Taxes must go up, right? Roth IRA is better! People who put money into Traditional IRA are not paying attention!”
I never want to see another Traditional vs. Roth IRA comparison article written after this one. If you find one, tell me about it.
Roth vs. Traditional IRA: Which is better?
Ok, I have a little surprise for you.
We are not going to talk about the differences between the Roth IRA and Traditional IRA accounts because that does not truly help. We’re going to talk about Tax Deferred and Tax Advantaged money vehicles.
Tax Deferred vs. Tax Advantaged: Which is better?
- It’s the question behind the question, and
- You are smart enough to find the info you need on income limits, contribution rules, deductibility, and other technical stuff that becomes important once you understand how each works and decide where you want your money.
If you skipped the rant: The technical details are important. I’m not saying to ignore them. Figure them out before you contribute. What I’m saying is that they don’t provide any value in making the decision before the basics are understood. If what you learn causes you to change your mind, it’s easy to go back to basics and start down another path.
So let’s get into it.
Understanding the Vehicles
A major benefit you will get from this is an understanding of how several other account types work. Because there are more places you can put your money than a traditional and Roth IRAs. Who knew?
Here’s a list:
|Tax Deferred||Tax Advantaged|
|401(k), 403(b), 457(b)||Roth IRA|
|Traditional IRA, SEP-IRA, SIMPLE IRA||529 College Savings Account|
|Qualified Annuity||Municipal Bonds|
|Pension plan||Cash Value Life Insurance|
|Health Savings Account (HSA)||Health Savings Account (HSA)*|
|Long Term Care Benefits|
|Disability Insurance Benefits|
* An HSA, if utilized to pay only medical expenses, has the benefits of a Tax Advantaged account for withdrawals. It acts like an IRA otherwise.
All tax deferred (advantaged) accounts work fundamentally the same way, though each has their own set of rules.
For example, in order for a 529 Plan to be truly tax advantaged, you must use the money withdrawn from the account to pay for educational expenses. If you try to use it to fund your retirement, it you’d call it a tax disadvantaged account.
The fundamentals of how each account treats your money is the foundation from which the technical details about the account can be built.
A picture is worth 1,000 words. And better than me explaining it in words.
Two are worth 2,000.
* And of course, there are exceptions. That’s why the asterisk at the withdrawal step. In order for each #4 statement to be true, you must follow the rules for the individual account. That’s where the technical details of the specific account you’re using comes into play.
It may seem like the Tax Advantaged vehicle is better because the only income tax paid is all in that tiny rectangle in the beginning.
That’s not necessarily true. We can see this by putting some numbers on the diagram:
Of course, this is assuming that the income tax rates do not change at all, ever. Not likely to be the case.
- If you expect to have a lower tax rate in retirement than you do today, money is best kept in a tax-deferred vehicle.
- If you expect to have a higher tax rate in retirement than you do today, money is best kept in a tax-advantaged vehicle.
Good. Now you know how each type of vehicle works, and what scenarios cause each to be better.
But you knew that already…
So, what the heck? Tax Deferred or Tax Advantaged, which is better?
It depends on what your income tax rate will be in the future.
So, I cannot tell you.
That’s the honest answer. And you were able to see for yourself without being inundated with useless technical information.
It’s what Nerdwallet said right in the very first paragraph of their article. The big difference between a Traditional and Roth IRA is when you pay the income tax.
Do you feel like you wasted time here?
Really, the biggest purpose of this post was to get you to think for yourself. Honest to God. Personal finance is not complicated. It only seems complicated because it seems like finance bloggers want to generate clicks.
I’ll cover other topics like Non-Deductible IRA, Backdoor Roth in a future post. They won’t be too difficult to understand given the foundational understanding you now have.
I still want to know which is better for my situation, Tax Deferred or Tax Advantaged.
What I can tell you are that there are two factors which will determine what your income tax rate will be when you retire and want to start pulling the money from your accounts. One factor you have next to zero control over, the other you have total control over.
- How much the government feels it can get away with taxing us.
Completely arbitrary. Individually, we have very little control over what our elected officials decide to do. Which really isn’t how elected officials are supposed to work, but I digress.
Who knows what this will be in the future? It seems that most people think tax rates might go up because of our staggering national debt, irresponsible politicians, and wasteful spending.
But they might go down. The debt might get paid off. We might end the Fed. We might elect non-corrupted politicians.
Who’s right? Only time will tell!
- What type and how much income you will have when you retire.
You have total control over this. What sort of lifestyle do you foresee for yourself in your retirement years? Will you keep working or stop as soon as you can? Will you have a business, rental properties, or other assets that bring in taxable income or just a big fat pile of savings to live off of? Will you live a more lavish lifestyle that requires a higher drawdown of your retirement accounts or will you tend towards minimalism? FatFI or LeanFI?
Some people believe they will have more income coming in when they retire. Others believe they will have less. It’s really up to you to decide this for yourself.
An easy way to diagnose this is to evaluate what sort of lifestyle you’re living today. If you’re doing the bare minimum required to scrape by, you’ll probably have less money in your retirement accounts, less income, and in a lower tax bracket as a result.
If you’re working your butt off, saving like crazy, and always looking for more ways to provide value to your fellow human, you’ll probably pay more taxes in old age. And, well, it probably won’t matter where your money is because you’ll have plenty of it.
I’m super worried, but I just want to optimize as much as possible
Fair. No matter how we end up living our lives, the first factor is almost completely out of our control.
What we can do to hedge our bets is Diversify our tax situation.
To show what that means, we’ll do a fun little experiment here.
Recall above the diagram of $100 going into both the Tax Deferred and Tax Advantaged vehicles to show that it doesn’t matter which vehicle you choose if tax rates remained the same. You’d end up with $1,950 at the end of the day either way.
For this example, we’re still going to assume that tax rates stay the same. But what happens when you have less income? Less taxes!
If you split up the $100 you made between a Tax Deferred and Tax Advantaged vehicle, your overall effective tax rate will be lower. So on both ends, you’ll pay less in taxes.
Of course, it’s not the ultimate solution, but diversifying across vehicle types does give you the added benefit of having flexibility when you want to make withdrawals in retirement.
0) Think for yourself.
1) First, understand how the different type of vehicles work, then build on top of that the technical details of the account you’re investigating. This fundamental vehicular understanding is useful in understanding many other account types as well.
2) There is no solid answer to the question. Anyone who claims that any account type is deterministically better is wrong. Unless they are a time traveler delivering a message from your future self, they may have an unconscious bias or a hidden agenda.
3) You can diversify your taxes by spreading money across different vehicle types. It may not provide any long-term benefit, but the flexibility it provides you may come in handy.