READER QUESTION: Traditional vs Roth IRA?

Q: Hello Jerry, I am a new Gold member and have a question about saving money in an Individual Retirement Account (IRA). I have heard you speak favorably about Roth IRAs in the past and am considering setting one up. (I am 27 years old.) Do you still think that Roth IRAs are a better option than a traditional IRA for young investors with a long investment time horizon? Thanks for all you do. – Sam R (Gold Member – Flagstaff, AZ)

A: Hi Sam, the key to answering this question is to ask yourself, “What kind of tax benefit do I need and/or prefer?”

The Up-Front Tax Deduction

The first type of tax benefit you can receive from an IRA is the tax deduction now. When you deposit money into a Traditional IRA, assuming you meet all other requirements, you receive a tax deduction up to the max of $7,000 ($8,000 if you are age 50 or older) for the current tax year.

This benefit is useful in two ways.

First, for those who need a tax break now, you get to keep your money in a savings account and get the tax deduction upfront.

Second, the money grows tax-deferred until you begin making withdrawals at age 59 ½ or later. Withdrawals are taxed as ordinary income at the rate you pay at the time of withdrawal.

In essence, you will end up paying taxes on your capital gains, dividends, and interest once you begin taking the money out if you opt to get an upfront tax break with a Traditional IRA. 

The Tax-Free Growth Benefit

The second type of tax benefit you can receive from an IRA is the “tax-free growth” benefit. You can take advantage of tax-free growth through a Roth IRA. Basically, when you contribute to a Roth, you do not get the tax deduction in the current year. Instead, you would pay your ordinary income tax rate on all contributions in the current year. However, the withdrawals you take from a Roth, beginning at age 59 ½ or later, are tax-free.

Therefore, all capital gains, dividends, and interest earned on the money are able to grow completely tax-free — and will be distributed back to you in the form of tax-free income.

One caveat is that you are technically not able to contribute directly to a Roth IRA if your modified adjusted gross income (MAGI) is over $161,000 (single) or $240,000 (married filing jointly) in tax year 2024. (There is, however, a back-door strategy for high-income earners.) Please see the IRS website or speak to your tax advisor for up-to-date data on IRA limits and income ranges.

Tax Rates: Will They Be Higher or Lower in Your Retirement?

One factor that I believe everyone should at least consider when deciding between a Roth IRA and Traditional IRA is whether you believe tax rates are going to increase in the future.

This is very important because, if you are like me and believe taxes will increase in the coming years, it may be smart to go ahead and pay Uncle Sam now (as much as you don’t want to!) instead of 20-30 years from now.

A quick look at the history of tax rates shows us that the highest marginal tax rate has averaged 59% since 1913 when the income tax was first introduced.

Currently, people in the top tax bracket only pay about 37%, which is well below the historical average. Furthermore, during the entire period between 1940 and 1963, the top marginal tax rate was above 80%. If you believe, as we do, that the U.S. government will need to raise more tax revenue to finance its reckless spending, then it only makes sense to expect tax rates to be (perhaps much) higher in the future.

For this reason, I prefer a Roth IRA over a Traditional IRA if my time horizon out to retirement is 15 years or more.

There are benefits to Traditional IRAs as well. Each offers its own features and benefits.

Setting Up an IRA

You can set up a Traditional or Roth IRA with almost any brokerage firm, like ETrade.com, and get access to invest in stocks, ETFs, and bonds.

However, you can also self-direct your IRA, which permits you to buy more than just stocks/ETFs with your IRA funds. With a self-directed IRA, you can invest in real estate, cryptocurrencies, and physical precious metals, as well as stocks and ETFs. Self-directed IRAs can be set up as Traditional or Roth, which is interesting and worthy of exploration because they allow you to invest in what you know best, even if it’s not stocks.

Of course, I am not a tax advisor so I would strongly encourage you to speak with a qualified tax pro (like a CPA) about your specific situation before making any financial decisions. There is wisdom in a multitude of counselors. You can also find a financial advisor from our own network here.