Trying to decide between Traditional or Roth

[Zoe]

We have some cash saved up and I was going to open an IRA for me and one for my husband. We will be able to put $5K in each account before April 15th. How do I figure which will be best? I was searching the forums on here and there was mention of tax brackets and other stuff that I didn't understand.

Thanks!

[sulaco]

No matter the tax bracket, you can contribute to a Roth IRA, you just have to do it indirectly over a particular income (around $170k for joint filers IIRC).

The major difference is when tax is collected. Traditional IRAs will have tax collected during distribution.  Roth IRAs are funded with after tax money and are able to grow tax free.

If you are a high earner, you are not allowed to contribute directly to a Roth IRA, but you can contribute to a Traditional IRA and immediately convert it to a Roth IRA.

[mushroom]

The main question is what is your tax bracket now vs. what is your tax bracket when you will be withdrawing or converting that money and when do you plan on doing so?

Traditional IRA is funded pre-tax, but you have to pay taxes on it later.
Roth IRA is funded post-tax, but once it's in there, you don't have to pay taxes on any of its growth down the road.

If you are in a high income bracket now, it probably makes sense to do a traditional IRA to avoid paying higher taxes now, and then convert to a Roth/withdraw at a lower bracket. If you are in a lower bracket and plan to leave the IRA money mostly untouched until much later in life, a Roth is nice when you really get compound interest working for you tax-free.

Roth has some extra advantages with flexibility over a traditional IRA as well - you can withdraw the principal (but not the interest) at any time for any reason. There are no mandatory distributions at a certain age like there are with a traditional.

It would be helpful to know what your income is now and what your plans for retirement are (are you going to retire soon? what kind of asset allocation do you plan to have in retirement? what do you expect your spending level to be?).

[Will]

Do both.  Why?  Well, do you KNOW whether you will be in a higher or lower tax bracket when you retire?  Maybe taxes will go up; maybe they will go down.  Since you can't know, and since you get identical returns whether it is in Roth or Traditional (because it is only the timing of the taxes that is different), why not both?

[mushroom]

There's also a thread going on now about traditional vs. Roth in https://forum.mrmoneymustache.com/ask-a-mustachian/taxes-and-401ks-i-think-i'm-missing-something/?topicseen

As you can see, the decision is not always clear cut.

[Zoe]

Thank y'all for the quick responses!

We are definitely in a lower income bracket, we gross under $50K/yr.

I like the idea of doing both. I ran each IRA scenario in TaxAct (we will have to file an amendment), and doing a Traditional gives us an additional $2,900 or so. Roth was only $333. So I definitely understand the pre-tax and post tax. If we do both, we could open a Traditional now, and then when we get the refund, open the Roth's and then contribute to each during the year. Good idea?

Here's another thing, I know every dollar counts, but since we're lower income we won't be able to max out all the accounts. We would have about $800-$1K every month to distribute to IRA's, savings for a house down payment, and other things that come up. Maybe one of us going back to school at some point. Would you contribute equally to each account?

[Zoe]

There's also a thread going on now about traditional vs. Roth in https://forum.mrmoneymustache.com/ask-a-mustachian/taxes-and-401ks-i-think-i'm-missing-something/?topicseen

As you can see, the decision is not always clear cut.

Yep, I read that one last night. It's mind boggling for me!

[sherr]

I like the idea of doing both. I ran each IRA scenario in TaxAct (we will have to file an amendment), and doing a Traditional gives us an additional $2,900 or so. Roth was only $333. So I definitely understand the pre-tax and post tax. If we do both, we could open a Traditional now, and then when we get the refund, open the Roth's and then contribute to each during the year. Good idea?

Here's another thing, I know every dollar counts, but since we're lower income we won't be able to max out all the accounts. We would have about $800-$1K every month to distribute to IRA's, savings for a house down payment, and other things that come up. Maybe one of us going back to school at some point. Would you contribute equally to each account?

No, if you are in a 10 or 15% tax bracket then you should not do both, instead do only Roth. Roth accounts were invented for you. :)

The only reason you should do both is if you think it's possible / likely that your taxes will be *even lower* in the future when you are withdrawing. Personally I think that's incredibly unlikely. The "both" advice makes a little bit of sense if you're in a 25% bracket and theoretically taxes could to either way (but I would still disagree with it). But in your case this is very likely to be the lowest tax rate you'll ever have, so you should lock in the low rate while you can.

[Zoe]

I like the idea of doing both. I ran each IRA scenario in TaxAct (we will have to file an amendment), and doing a Traditional gives us an additional $2,900 or so. Roth was only $333. So I definitely understand the pre-tax and post tax. If we do both, we could open a Traditional now, and then when we get the refund, open the Roth's and then contribute to each during the year. Good idea?

Here's another thing, I know every dollar counts, but since we're lower income we won't be able to max out all the accounts. We would have about $800-$1K every month to distribute to IRA's, savings for a house down payment, and other things that come up. Maybe one of us going back to school at some point. Would you contribute equally to each account?

No, if you are in a 10 or 15% tax bracket then you should not do both, instead do only Roth. Roth accounts were invented for you. :)

The only reason you should do both is if you think it's possible / likely that your taxes will be *even lower* in the future when you are withdrawing. Personally I think that's incredibly unlikely. The "both" advice makes a little bit of sense if you're in a 25% bracket and theoretically taxes could to either way (but I would still disagree with it). But in your case this is very likely to be the lowest tax rate you'll ever have, so you should lock in the low rate while you can.

I see. Good explanation! Thank you!

[mushroom]

I would definitely go for the Roth in your situation...unless your income is such that doing traditional IRAs would bring your AGI under the cutoff for Saver's Credit.

What I mean is that there is an amazing credit for low-income earners who save for retirement with a cutoff of about 34,500 AGI or so for married filing jointly (higher if you have kids), where you can get a $2000 credit back for investing in any retirement accounts (roth, traditional, 401k, whatever), meaning that at that income level it erases all of your federal tax liability.

Even if you're above 34,500, there's a transition zone up to 57,500 where you can get a smaller saver's credit back. It probably makes sense to just do the Roth if you're stuck at >34,500. But the most lucrative is definitely if you can get under 34,500 by contributing enough to traditional IRAs to bring your modified AGI under that cutoff.

[mushroom]

Forgot I was going to include some links :)

http://www.irs.gov/uac/Get-Credit-for-Your-Retirement-Savings-Contributions

http://www.irs.gov/pub/irs-pdf/f8880.pdf

I <3 Saver's Credit.

[Zoe]

Good deal. I think we're settled on Roth's. I was just now setting mine up and it asked which funds I wanted. Um, I have no idea?

My work 401K is Target Retirement 2050. I have no idea what funds for the IRA though. Suggestions?

[sherr]

You probably should spend some time in the future and read through the links posted here: http://www.mrmoneymustache.com/2013/03/07/how-about-that-stock-market/

Those are an excellent introduction to the stock market and investing, and will help you understand what's really going on (although the author misses the boat a bit on over-recommending Roths IMHO). Short answer though: a whole stock market index fund or S & P 500 index fund are excellent places to start.

[Zoe]

Thanks! I did read through that the other day, but it's bookmarked now so I can really read and understand it.