Not long ago I received the following inquiry from a subscriber to my newsletter: “I understand that an IRA account can be a good device for retirement planning. I’ve done some investigating, but am confused as to whether a traditional IRA or a Roth IRA is better. Can you provide some advice on this matter?” In drafting my response, it occurred that a good number of persons might want an answer to that question. So, if this subject strikes a chord with you, read on.
Before we attempt to weigh the pros and cons of the two federally designed Individual Retirement Accounts (IRAs), I’ll provide a brief overview of each program. The traditional (or ordinary) IRA is by far the older of the two, introduced in 1981 to provide Americans with a tax-favored means of saving for retirement. In its current operation, any taxpayer may contribute up to $4,000 annually of earned income into an established account.
Such contributions are tax deductible, with the account’s subsequent earnings tax-deferred until eventual distribution after the holder reaches 59ï¿½ years. By contrast, the Roth IRA, which originated in 1998, is not available to persons whose annual gross income exceeds certain amounts (generally $110,000 for single persons and $160,000 for married persons), nor are its contributions deductible in the year made.
However, all income generated by and eventually distributed from the account is tax-free during its lifetime. For a thoroughly understandable summary of the specifics of each program, you can pick up Publication 17, Your Federal Income Tax, at any IRS office, and review the dozen pages comprising Chapter 18 titled “Individual Retirement Arrangements (IRAs).”
Presuming you’ve now familiarized yourself somewhat with the details, it’s time to broach the original question: Which IRA, the traditional or the Roth, is better? As you might guess, I harbor some strong opinions. It is my belief that if your gross income does not render you ineligible, the Roth IRA is by far the preferable choice. Although it’s true that you’ll not get tax deductions for the contributions, you’ll receive something far more valuable — all income and appreciation generated in the account will be forever free (at least as long as the laws are not changed).
I’m convinced that if you can anticipate participation for at least twenty years, this more than makes up for the deductions that the traditional IRA generates, but which is tax-deferred rather than tax-free. Perhaps, in all fairness, we must not ignore a contrary claim that deductions taken at higher marginal brackets during the working years will more than offset the taxes paid on post-retirement distributions at lower rates, thereby favoring the traditional IRA. In response to this, it’s my contention that persons who conduct their financial lives wisely will find themselves in substantially higher brackets is later years.
Furthermore, with federal deficits rising, along with a prevalent tax-the-rich attitude of the electorate, the tax-free distributions to be garnered in future years might well be more beneficial than deductions received in earlier years. I’ll concede, however, the possibility that the laws governing Roth IRAs may be radically changed at some time in the future by a hostile legislature, and approved by an indifferent executive. If ever Roth distributions become retroactively taxed to persons in certain higher income groups, all bets are off.
In comparing the two types of IRAs, there’s a companion matter that warrants consideration. If you previously opened a traditional IRA, but now wish it were a Roth, a way exists to make the conversion. This is known as a “rollover.” The downside is as you might guess: The transaction requires that you pay income taxes at ordinary rates on the entire transfer, although thankfully the 10 percent penalty for early distribution is not applicable.
In contemplating such a maneuver, you must estimate whether, as a Roth, the assets after the tax bite will provide greater after-tax retirement income than it would as a traditional. It’s my belief that for account holders no older than about 35, the rollover will prove advantageous over the long haul. For persons above that age, it probably won’t pay for itself.
Now that I’ve expressed my preference as to type of IRA, I’d like to scratch beneath the surface a bit. Although we’ve viewed this device as an investment vehicle, we’ve not yet discussed what belongs in it. Of course there is no shortage of advice in the investment community on this subject. If you tune in regularly to the nation’s financial advisers, you’re aware that the recommended holdings in a retirement account are a mixture of broad-based mutual funds, often with heavy emphasis on index funds. It gives me no particular pleasure to heartily disagree, but I’m convinced that assets of an entirely different nature belong in a Roth IRA.
My preference is for interest-bearing vehicles as the sole investment. These will be gilt-edge securities such as U.S. treasury notes and bonds, FDIC-insured certificates of deposit, money market accounts, and high-grade corporate bonds. The benefit to be gained is unique: You will reap the rewards of compound interest — the closest thing to magic you’ll ever see. If started early enough in life, such an account may well accumulate a million dollars tax-free by the time of retirement. There’s insufficient space here to go into greater detail, but for additional information on this subject you’re invited to visit my website, www.onthemoneytrail.com, click onto Newsletter Archives, and read December 2002, “Why Bonds Belong in a Retirement Account.”