Traditional IRA vs. Roth IRA – The Final Battle
Many people have written about Traditional IRAs and Roth IRAs but when asked which one is better, the common response is, “it depends”.
One of my objectives as the Mad Fientist is to analyze common investment vehicles and financial advice, focusing on how they pertain to someone pursuing FI, and use what I learn to create optimal strategies to help both you and I reach financial independence as quickly as possible. A few months ago I investigated HSAs in the Ultimate Retirement Account article and today, I’m going to tackle the Traditional IRA vs. Roth IRA debate and show that one actually is better than the other for future early retirees.
Types of Retirement Accounts
Before I get into the specifics, let me first recap the two major types of retirement accounts.
Tax-Free Contribution Accounts
The most common type of retirement account is one in which you use pre-tax dollars to fund the account, the investments grow tax free, and the withdrawals from the account are taxed as ordinary income. Traditional IRAs, 401(k)s, and 403(b)s are all examples of this type of retirement account.
Tax-Free Withdrawal Accounts
A tax-free withdrawal account, on the other hand, accepts after-tax dollars, grows tax free, and then allows completely tax-free withdrawals. A Roth IRA is an example of this type of account.
They Both Sound Good
Both are good because they provide some tax benefits that allow your investments to grow faster than they would if they were invested in a normal taxable account.
When choosing between a Traditional IRA and a Roth IRA, you are effectively choosing when you want to pay tax on your money. If you decide to go with a Traditional IRA, you pay your tax when you withdraw the money and if you go with a Roth IRA, you pay the tax up front.
There are some other differences between the two types of accounts but rather than go into it all, feel free to check out this article for a nice comparison.
Get the Best of Both Worlds
What I’m going to show you today is that, with a little bit of planning, it’s possible to get the best of both worlds!
Here’s the strategy…
Step 1: Contribute to a Traditional IRA During Your Working Years
While you are working, your taxable income is likely higher than it will be after FI so it makes sense to shield as much of that income from the taxman as you possibly can by contributing to a tax-free contribution account.
Step 2: Slowly Convert Traditional IRA to Roth IRA
Once you begin your early retirement, you will be earning less than you were when you were working so use this period of lower income to convert your Traditional IRA to a Roth IRA. Determine how much of your Traditional IRA you can convert each year, tax free, and then slowly convert to a Roth IRA until your entire balance has been converted (IRA conversions count as ordinary income so adjust the amount you convert each year based on how much you withdraw from your taxable investments for living expenses).
Step 3: Enjoy Your Completely Tax-Free Retirement Money
When you reach 59.5, your conversion should be complete so you’ll be able to withdraw money from your Roth IRA completely tax-free!
How is This Possible?
You may be wondering why everyone doesn’t do this? Well, there are a few reasons this strategy is only feasible for early retirees.
Low Living Costs
Early retirees are usually able to live on modest amounts of income that generally come from tax-efficient sources like long-term capital gains and dividends. Long-term capital gains and dividends aren’t taxed at all unless you are in the 15% tax bracket or above. That means someone could happily live off of $45,000 of long-term capital gains and dividends without paying income tax.
Long Conversion Timeframe
Since conversions from a traditional IRA to a Roth IRA are taxed as ordinary income, it is beneficial to spread your conversion over a large timeframe so that you don’t increase your taxable income too much in any given year. Since normal people work full time until they reach retirement age, any amount converted will increase the amount of tax they have to pay. However, an early retiree can comfortably live off of $30,000 per year, for example, and gradually convert $9,000 to their Roth IRA per year without having to pay any tax on their income or conversion.
Check out this tax calculator to see how much you can convert (ordinary income) and earn (long term capital gains, dividends, etc.) before you have to pay any tax. I plugged in $9,000 of ordinary income, to account for the Roth IRA conversion, and then $30,000 divided between long-term capital gains and dividends and it correctly computed $0 of tax owed.
So What’s the Big Deal?
An example will help clarify how this works and will highlight how much money this could save you over the long run.
Imagine two 30-year-olds who hope to retire by the age of 40. To make things simple, assume they each start with nothing, make $60,000 a year, and can happily live off of $18,000 per year.
Investor A decides to max out his Roth IRA between now and when he retires at 40. Investor B instead decides to max out his Traditional IRA and then slowly convert it to a Roth IRA after he turns 40. Both invest all additional income into taxable accounts.
The following graph shows the value of the accounts of these two investors.
Investor A is represented by the light green lines and Investor B is represented by the dark green lines. The solid lines represent the investors’ normal taxable accounts, the dashed lines represent the investors’ Roth IRA accounts, and the dotted line represents Investor B’s Traditional IRA account.
As you can see, at age 40, both investors stop contributing to their accounts and begin withdrawing $18,000 per year from the taxable accounts. Investor B also begins converting his Traditional IRA into a Roth IRA at this time. Thanks to the fact that he is able to live on a reasonable income and has time to slowly convert the Traditional IRA into the Roth IRA, he is not taxed on the conversion and therefore ends up having exactly the same amount of money in his Roth IRA as Investor A does when they both reach standard retirement age.
What you’ll notice though is that Investor B actually has quite a bit more in his taxable account. Since he was able to invest pre-tax money in his IRA when he was working, he had more money to invest in the taxable account during his 30s and as a result, will end up with over $100,000 more than Investor A when he reaches retirement age!
It’s pretty incredible that a simple choice between two good options could result in a six-figure difference in retirement savings!
Why Stop There?
In the Ultimate Retirement Account article, I described how an HSA could be used as a completely tax-free retirement account. In this article, I’ve shown how a Traditional IRA could also become a completely tax-free retirement vehicle when combined with a Roth IRA. What about the other major retirement accounts like the 401(k) and 403(b)? Yes, they can also potentially become completely tax free!
Tax-Free 401(k)
Thanks to the ability to convert your 401(k)/403(b) to a Traditional IRA, it is just one extra step to get get your 401(k)/403(b) money into a Roth IRA.
Suba at Wealth Informatics just wrote a post on how to convert your 401(k) to an IRA so take a look at that article to see how it works. Once you get your money from your 401(k)/403(b) into a Traditional IRA, you can then slowly convert it into a Roth IRA using the method above!
Conclusion
To summarize the strategy, max out your tax-free contribution accounts while you are working, use your early retirement years to slowly convert those accounts into tax-free withdrawal accounts, then enjoy your standard retirement years knowing that most of the dollars you spend are completely tax free!
So, what do you think? Will this strategy work for you? Do you expect your income after FI to be low enough to allow for completely tax-free conversions?
Image: thrumyeye
Great article, MF…
Clear, concise and a cool strategy. I liked it so well, I linked to it on my own post on the subject.
OH, and neat picture of the fighting foxes.
Thanks, Jim! The post that you referenced (http://jlcollinsnh.wordpress.com/2012/05/30/stocks-part-viii-the-401k-403b-ira-roth-buckets/) is actually one of my favorites of yours because it not only describes the various types of retirement accounts but it also discusses which investments should go into each type (or “bucket”, as you say) to maximize tax efficiency.
Ha, I’m glad you like the foxes image. It’s hard to find an image to represent a battle between two types of retirement accounts!
Great Analysis FI!
I would also add:
1) Keep in mind that there is a 5-year holding period (lockout) when you convert a Traditional IRA to a Roth IRA. That is, the investor must wait 5 years before withrawing the originally converted amount.
2) In some cases it may make sense to make the original contributions to a Traditional IRA/401k, then withdraw desired amounts from the IRA/401k before age 59 1/2 (yes, PAYING THE EARLY WITHDRAWAL PENALTIES) if the IRA/401k contributions during working years are in a high tax bracket, and the withdrawals in retirement/early retirement are in a low tax bracket.
Thanks, GubMints! You make two great points. Your second point highlights why I take a “get all the tax breaks I can now, worry about getting my money out later” approach. I’ve already exceeded the amount of post-standard-retirement-age savings I need to accumulate but I still keep maxing out my tax-advantaged accounts because to me, the tax breaks are worth the added hassle of getting my money later (if I decide I need some of it before I turn 59 1/2). As you said, the worst-case scenario is I’d have to pay early withdrawal penalties but since my tax bracket will most likely be much lower after I reach FI, I could still end up being better off even after the penalty.
Whenever I stumble upon such discussions of roth vs. traditional IRA, the considerations always seem to be whether one’s income would be lower or not at retirement (hence a lower or not tax bracket) or whether the tax rates will increase in the future (a very popular belief in Canada).
I think that these are minor factors and for most people hard to predict. For most people without (or with small) pension plans traditional IRA’s are better for the simple reason that the tax savings during contributions are at marginal rates, while the withdrawals are at average rates. This is of course why the conversion strategy proposed in this post works.
There’s an added advantage for people living in high tax states – they can change their residency after retirement.
So my conclusion is that for people without significant defined benefit pension plans or with huge savings, saving in a traditional IRA’s is the faster way to secure comfortable retirement income.
For me, my first priority is to make sure that I’ll not be on the street or a burden to my children. After that, if I’ve managed to save a ton of money, who cares if I pay a bit more in taxes. Security first, then getting rich!
That’s a great point, Pat. Trading a marginal tax rate for an average tax rate makes sense no matter what you think tax rates or your personal income will be in the future.
That’s also a good point about being able to move to a state with lower taxes after retirement. This is actually something I plan on writing about in the future. Because I’ll be living abroad for a good part of my life after FI, I’ll need to investigate which state would be best to establish residency in prior to leaving America. The last thing I’ll want to do is pay a bunch of state taxes when I’m not even living in a state.
FI – Thanks for this post; it leaves me with lots to think about. My strategy throughout my 20′s was to plow as much money into my Roth 401k and Roth IRA as possible due to the obvious benefits of no taxation in retirement; however, since the early retirement bug bit me in the past year when I found ERE and MMM (and now your blog today), I’m not so sure . . . .
Right now, my current investments are about evenly split between Roth and Traditional retirement accounts (Roth: IRA rollover from prior employer Roth 401k, current contributions to employer Roth 401k, and current contributions to Roth IRA; Traditional: 401k matching from current employer, 401k rollover from prior employer, plus the ever popular Ultimate Retirement Account (aka HSA)). The big drag on getting to FI are my wife’s student loans, so if I switch my current 401k contribution from Roth to Traditional, then I can plow the extra money from my paycheck into reducing her loans. Then, once we retire early, I can gradually convert my Traditional to Roth in a tax free manner as described above.
What are your thoughts on Roth 401k plans? (forgive me if you’ve covered this in prior posts – I searched but I couldn’t find any mention of them)
Looking forward to reading more great posts; you’re in my RSS reader! :)
Welcome, Tom! Your path through ERE and MMM to get here puts some serious pressure on me to deliver so I’ll try my best.
That’s a great idea to switch over your contributions from a Roth 401(k) to a Traditional 401(k) in order to help pay off your wife’s student loans faster. Paying off debt would be a great way to use the extra money you save from investing in a pre-tax retirement account, especially if the interest rate on the loan is high.
As far as Roth 401(k)s are concerned, I don’t think I’d ever utilize one personally but not because they’re bad. I just think the benefits of tax-free contributions far exceed the benefits of tax-free withdrawals so I’d always choose a Traditional 401(k), when given the choice. I want as much of my money working for me as long as possible so the less taxes I pay up front, the better. I have confidence that I will be able to optimize my withdrawal strategy to limit my tax burden later in life so that’s why I’m comfortable only funding tax-free contribution accounts during my working years.
Thanks a lot for stopping by and I look forward to hearing more about your journey to FI!
Hi Tom,
2c from me, if you don’t mind. As I wrote previously, I believe that traditional accounts provide a better opportunity for tax avoidance. Roth IRA’s have two main advantages (from my personal perspective); (1) their treatment when inherited, and (2) more investment choices compared to 401(k)’s (e.g. I do some futures trading).
Point (2) obviously does not apply to roth 401′s. As for (1), if I remember correctly rolled over roths are not treated the same way as “original” roths when inherited.
Having said that, I’m on the revenue increase side of the US fiscal debate and encourage people to pay more taxes. So, please, do go ahead with the Roth 401 contributions. My children need your taxes :)
Hi,
I love your website. I found you through J and MM. Question…. Can you roll over the IRA when you are still working to avoid taxes later or does this only work when in a lower tax bracket and not working as much?
Thanks
Hi Andria, good to hear from you again. I’m glad you’re enjoying the site!
You can roll over your traditional IRA into a Roth IRA while you are still working but you would have to pay tax on the amount that you roll over. Say you are in the 25% tax bracket, you’d pay at least 25% tax on the amount you convert because the conversion would be in addition to your ordinary income.
newcomer to your site. love it. I have two questions, that may be obvious to others but aren’t really to me as I’m still educating myself on all this.
1) Aren’t your contributions to a Traditional IRA limited to $5500/yr for individuals? I know employer sponsored 401ks are like $17K or so, so that’s not nearly as low, but my understanding is that as an individual you can’t increase your contribution to individual IRAs beyond %5500. I gotta be missing something right? Next question is part of the reason I’m asking.
2) My wife is an independent contractor. Initially, I had thought about using our Roth IRA to double as an tax-savings investment account should we owe taxes on her income next year (you can pull some or all of your principle contributions on the roth and, from what I read, replace it penalty free within 60 days w/o adding to your contribution limit). Your article here has me wondering if my wife contributing a major chunk of her IC earnings to our traditional IRA would mitigate her tax liability next year? Am I right about this, or missing something?
Again, fantastic article. I came to you through MMM and J as well, and for me you really hit a great balance between those two guys. You all compliment one another well in your approaches and styles. Esp loved your ‘get a university job’ article
Welcome, Ryan! I’m really glad to hear you’re enjoying the site.
To answer your questions:
1) You are absolutely correct. The IRA contribution limits are $5,500 for individuals in 2013 (subject to income). On the graph in the article, you’ll notice that the IRA balances only increase by $5,500 (plus investment earnings) per year for the first 10 years, at which point the two individuals stop contributing and leave the investments to grow until standard retirement age.
The max you can contribute to a 401(k) in 2013 is $17,500 so it allows you to shelter even more of your income from tax. I am still maxing out my 401(k), even though I have more than enough saved for post standard retirement age, because I plan on using the method described in this article to convert most of that 401(k) money into a Roth IRA, tax free.
2) Interesting idea using your wife’s Roth as a tax-savings investment account. I like that idea, as long as you have a backup plan if your investments tank! You also have to figure out if it is worth the added hassle of keeping track of everything for the IRS for a few months of tax-free growth. I personally don’t keep a lot of cash around (for an emergency fund, for example) because I know I could tap into my Roth IRA if I needed cash for something unexpectedly but I’m not sure I would put money into a Roth if I knew I was going to withdraw it again in three months for a quarterly tax payment. I just hate dealing with the IRS so anything that could potentially involve more paperwork, I tend to shy away from (unless the benefits outweigh the additional hassle).
Contributing to a Traditional IRA would lower your wife’s taxable income but I’m not sure how much she makes so I couldn’t say whether it would mitigate her tax liability completely. A lower tax burden is always a good thing though so if she is able to contribute to a Traditional IRA, that’s probably what I’d do!
Thanks for the thorough response! That all makes sense. I should have paid closer attn to your graph :)
Technically my wife’s income is considered self-employment so we don’t pay estimated taxes, just the self-employment tax come tax time. Also, she doesn’t bring in much, ~$12K for the year. I have a salaried job and contribute to our 401K tho I’m a ways from maxing it out. Our Roth IRA is all Vanguard stock/bond index mix, so I’m not too worried about it’s volatility. We also view it as an emergency fund (absolute last ditch, life-threatening, don’t ever plan on tapping it fund), and initially I had thought it might double as a better place than a savings acct to stash potential tax bill $. However, the traditional IRA seems better, and we already have one (also Vanguard target retirement index mix).
Thanks again!
Great article–it’s made me consider this as a strategy, and I’m doing the math and schedule for myself. I did the same detailed research about mortgage pay-off. The wisdom is that we should pay our mortgage off early to free up money, but after spending days running the numbers, I changed my strategy and am NOT paying off my mortgage early.
Thanks, GP FI. I too reached the same conclusion with my mortgage.
Let me know how the Traditional vs. Roth IRA numbers work out for your situation.