In the personal finance world an often debated topic is whether to contribute to the Roth IRA or the traditional IRA. An IRA stands for individual retirement account. The two accounts are mutually exclusive. The IRS currently allows you to contribute 5,500 dollars per year to IRA accounts (6,500 if you are over the age of 50). The two account have different tax advantages. The Roth IRA allows you to withdraw earnings tax free but requires you to contribute to with after tax dollars. The traditional IRA differs in that the traditional IRA allows you to contribute with before tax dollars, but requires you to pay income taxes on the withdraws.
So how do you choose which account to contribute to? The first step is understanding the problem. The problem is that without using IRA’s you are being inefficient from a tax standpoint. What IRA’s do is help you defer your taxes until a later point. The value in this is that we live in a progressive tax environment where as you earn higher and higher amounts of money you pay a progressively higher and higher rates of tax on each dollar you earn. If you are able to spread out when you take income and pay taxes on certain amount of money you will be able to put more money into the lower tax brackets.
A Quick Example
Albert and Bob are both are average gold miners. They both earn 88,000 per year. Albert takes advantage of his traditional IRA to the maximum and Bob doesn’t use it at all. The table below shows how much difference there will be between the two of them in just the last ten years leading up to their retirement. In the example I’ve assumed they are both single filers and take all the standard deductions and exemptions.
So using an IRA is clearly helpful. Albert saved $4,238.75 when compared to Bob.
Now to optimize between choosing a Roth IRA and traditional IRA I like to start with the best case scenario for how a person would go about minimizing taxes over their entire life. What would that look like? In the chart below I’ve shown the average college graduates income in two different cases. The first is the optimal income scenario and the second is the typical income scenario. If you wanted to pay the absolute minimum amount of taxes you would take the amount of money you are going to spend over your lifetime and take it as income evenly over the number of years you are going to live, so from 14 to whenever you kick the bucket (average life expectancy in the US is 79 years). In the typical scenario I’ve shown what a typical college graduate’s income looks like over their lifetime. At first you have relatively little income and as you acquire more human and skills capital your earning potential increase.
Clearly the optimal case won’t play out very often, because no 14-year-old is going to have near the salary to get close to their average life time yearly spending. This ideal scenario does give us a helpful clue about where we should be hunting though.
When taxable income is low compared to life time average we should be looking to increase taxable income and when taxable income is high we should be looking to minimize taxable income. I’ll spare you the math this time but the optimal point for when traditional IRA’s are better than Roth IRA’s is when your future spending needs are less than your current taxable income. When your future spending needs are less than your current taxable income you are better off delaying when you pay taxes on money until later in life when you are able to fit more money into a lower tax bracket. This is actually the case most of the time. There are only a very select number of years at the start of a person’s earning history when their future spending needs are higher than your current taxable income. This is because more than likely your spending needs now are similar to what they will be in the future and unless you happen to be going further into debt every year your income in currently covering your spending needs and some additional savings.
KEY ASSUMPTION AND MAJOR RISK TO CONSIDER
Stable tax environment. This is a safe assumption if you are a typical wage earner. Historically speaking, effective tax rates for the middle class have not fluctuated significantly. All bets are off if you are making enough to be in the top tax bracket. Then again if you making enough money to be in the top tax bracket you likely are ineligible to use many of the advantages of an IRA. If you think our current tax environment is unstable you may want to diversify between both types of IRA’s in case future tax rules are changed.
Limited liquidity needs. Both type of retirement accounts perform much better when held as equities for a long period of time. If you will need cash from your IRA in less than a few years an IRA might not be the best option for you.
- Forecast / estimate your future spending needs.
- Compare that to your current taxable income.
- If your future spending needs are lower than your taxable income, then choose the traditional IRA.
Most of the time, choosing a traditional IRA is the optimal solution.
The Roth IRA in my opinion is not a useful retirement account because when your taxable income is low compared to your future spending needs you won’t have the ability to save money because you are not as likely to have enough cash to fund your current spending needs, much less fund a retirement account as well.