The right IRA for you

NEW YORK (Money) -- Question: If you contribute to a traditional IRA, after many years most of your account value will be in the form of investment earnings, which are taxable when you withdraw them. With a Roth, on the other hand, your balance will be tax-free. So it seems to me that the advantage of tax-free withdrawals from the Roth in the future greatly outweighs any tax-deduction benefit you get from a traditional IRA. Doesn't that make the Roth a better deal? - Daniel Siroky

Answer: A lot of people aren't quite sure how to assess the value of contributing to a traditional IRA vs. doing a Roth. That's not surprising, given the number of factors that can affect which is the better choice for a given person in a given circumstance.

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Generally, I think having at least some money in a Roth IRA (or Roth 401(k), if that option is available to you) is good idea for several reasons. But before I get to them, I'd like to step back and explain how both traditional and Roth IRAs work in a way that, I hope, will give you and others a better understanding of them and help you decide which type to fund.

I'll start by stating a premise that many people overlook or simply don't understand about traditional and Roth IRAs - namely, that theoretically at least, they're equal in terms of the tax advantages they offer. This isn't immediately apparent. And I've talked to many people, including advisers, who don't seem to get this. But I think a little example will show you what I mean.

Let's say you've got $4,000 that you can put into either a traditional or Roth IRA. (The maximum IRA contribution for this year is $4,000, plus $1,000 if you're 50 or older; next year, the max goes to $5,000, plus $1,000). And let's assume that you'll earn 8 percent a year on your contribution for 20 years.

If you invest your four grand in the Roth, you'll have $18,644 in your account after 20 years. And, assuming you meet the withdrawal criteria, every cent of that money will be tax-free. If you put the $4,000 in a traditional IRA, you'll also have $18,644 after 20 years. But you'll owe tax on withdrawals. So if you're in the 25 percent tax bracket, your balance is worth only $13,983 after taxes, much less than the Roth.

But hold on. You also get a tax deduction with the traditional IRA. So to make the comparison even, you've got to factor in the value of that deduction. If you're in the 25 percent tax bracket, a $4,000 deduction saves you $1,000. If you invest that $1,000 and earn 8 percent for 20 years, you end up with $4,661. Add that to the traditional IRA's after-tax balance of $13,983, and you end up with $18,644 - exactly what you've got in the Roth.

Remember, though, I said the traditional IRA and Roth IRA are theoretically equal. In the real world, even if you were disciplined enough to invest your $1,000 savings from the traditional IRA's tax deduction, you would have to invest that money in a taxable account since you had already reached the annual IRA contribution limit.

So you won't get an 8 percent return a year after taxes. You'll get something less than that. Which means your $1,000 will grow into something less than $4,661. Which means that even after factoring in the value of your traditional IRA's deduction, the Roth IRA still comes out ahead.

So all things being equal, the Roth has an advantage. It effectively allows you to shelter more money from taxes. Congress could have adjusted for this by setting a lower contribution ceiling for Roths, essentially lowering the Roth limit as you move into higher tax brackets. But it didn't.

Ah, but let's not be so quick to assume that just because the Roth has this advantage that it's automatically the better deal. In fact, reality can intrude again in a way that can whittle down or even eliminate the Roth's advantage. How? Well, it comes down to tax rates.

When I compared a Roth to a traditional IRA in the example above, I assumed that you were in the same tax bracket, 25 percent, when you withdrew your money as you were when you contributed to it. But what if everything in the scenarios I described above remained the same, except that you dropped to, say, the 15 percent bracket in retirement when you were ready to dip into your IRA accounts?

Well, in that case, you would have $15,847 ($18,644 minus 15 percent, or $2,797 for taxes) after-tax in your traditional IRA, which is more than the $13,983 you had with a 25 percent tax rate. That would leave you just $2,797 short of the Roth.

That means as long you earned roughly 5.3 percent or more annually after-tax on your $1,000 tax-deduction savings - or, in other words, as long as you gave up less than a third of your annual return to taxes, which I think is doable if you invest in something reasonably tax-efficient like an index fund or tax-managed mutual fund - then you would come out ahead in the traditional IRA rather than the Roth.

In short, the tax rates you face prior to and at the time you withdraw your money can also determine whether a traditional IRA or Roth is a better deal.

Generally, if you expect to be in a lower tax bracket at retirement than you were when you made the contribution, then the traditional IRA is the better deal since you're effectively avoiding tax on your contribution and earnings when the tax rate is higher and paying it later when the rate is lower.

If you expect to be in a higher bracket when you withdraw the money, then Roth is the better choice because you're paying tax at a lower rate and avoiding tax when the rate would be higher.

And if you expect to stay in the same bracket, the Roth is the better choice because of its inherent advantage of effectively sheltering more money. As a practical matter, however, we can't always know whether we'll be in a higher, lower or the same tax bracket in the future.

Most people probably expect that their taxable income will fall in retirement, dropping them to a lower tax rate. But if you save like a demon and have tons of money in tax-deferred accounts like a 401(k), the withdrawals could push you into a higher bracket, at least in some years. And, of course, there's always the possibility that Congress could raise rates in the years ahead.

Which brings me back to my position that I think it's a good idea for most people to have at least some money in a Roth. Most people are likely to have the bulk of their retirement savings in a regular 401(k), which means withdrawals will be taxable (except, of course, any nondeductible contributions, if you made them). So a Roth provides a way of diversifying your tax exposure and gives you more flexibility for managing withdrawals (and your tax bill) in retirement.

If it appears you're about to move into a higher bracket in a given year in retirement, for example, you can pull tax-free money from your Roth. But there are also other reasons to do a Roth. Whether you want to or not, you've got to begin making required minimum draws from traditional IRAs after reaching age 70 1/2.

With a Roth, however, you can leave your money in there to compound tax free as long as you want - and even give the gift of tax-free returns to your heirs. And unlike withdrawals from IRAs and 401(k)s, the money you pull from a Roth isn't counted in determining whether any of your Social Security payments are taxed. So having access to a Roth could help keep the IRS's mitts off your Social Security benefits. (To see whether your Social Security benefits are likely to be taxed, click here.)

To sum up, it's tough to say whether a traditional IRA or Roth is always a better deal for a given person. But for the reasons I've laid out in this column, I believe it's a good idea for everyone to consider putting at least some money in a Roth, whether you do so through regular annual contributions, converting a regular IRA to a Roth or, if those routes are out, doing a nondeductible IRA that you later convert.

Even if it turns out in retrospect that the Roth wasn't the best deal, having access to a pot of tax-free cash can still give you peace of mind and a bit of maneuvering room in retirement.