Roth vs. Traditional IRA: Have The Rules Changed?

For years, we’ve heard the same story when it comes to investing for your retirement. If you fall into the tax brackets where you can invest in a Roth IRA, do it. The theory’s always been that since you pay taxes on the front end of a Roth, allowing your investment to grow tax free, that you’d be able to make more money over time. That’s been especially true since 2001, when the first of the so-called Bush tax cuts (the official name is the Economic Growth and Tax Relief Reconciliation Act of 2001) became law.

But now that President Obama and Congress have permanently extended those tax cuts for 98 percent of us, have the rules of the game changed when it comes to investing in a Roth IRA compared to a traditional IRA?

Reviewing The New Tax Cuts

Since Congress didn’t pass new legislation on or before December 31, 2012, the Bush-era tax cuts were allowed to expire. For a day or two, they rebounded to the Clinton-era tax rates, before Congress and the President signed the new Obama tax legislation into law. In other words, these were truly tax cuts on income under $400,000 for individuals and $450,000 for families.

The Rules Haven’t Changed…But Everything Else Has

Although the rules for contributing to a Roth IRA haven’t changed – the contribution limit has gone up to a maximum of $5,500 per person ($6,500 for individuals age 50 or older) for the 2013 tax year – some investors are looking at their Roth accounts a little differently now.

Now that we have assurances on tax rates for years to come, the argument that you need to invest in a Roth instead of a traditional IRA because tax rates during your retirement years will be unpredictable doesn’t hold as much water. The fact is, if you qualify to contribute up to those limits into a Roth – meaning you make less than $178,000 as a married couple filing jointly or more than $112,000 for an individual – then your tax rates haven’t changed, and likely won’t (yes, this is a point of contention and debate politically, but this article isn’t about politics, it’s about investment strategies).

Will You Do Things Differently?

I’m still trying to decide for myself whether or not (1) I actually think the permanence of these tax cuts has the potential to affect retirement investments and (2) if I should change mine in any way to accommodate these new tax rates.

What do you think? Am I way off course here, or are any of you thinking of putting more pre-tax money into a traditional IRA instead of a Roth now that tax cuts for most of us have been “guaranteed” in perpetuity?

8 Responses to Roth vs. Traditional IRA: Have The Rules Changed?

  1. Jean says:

    I may be whack here, but isn’t the real decider the fact that when you pay tax on it now (Roth), you pay on the smaller, UN-interest-earned amount, but if you wait to pay taxes (traditional), you will have earned interest & be paying more taxes b/c it’s more $ ?? That was the presumption I was working under.

  2. I am unable to contribute to a ROTH anymore due to our salary, so I really do not know. Traditional is the only way I can go. I look forward to seeing the comments!

  3. I’m keeping mine in a traditional. Clearly I’m the expert you were hoping would weigh in!

    • @Kathleen, Frugal Portland, The Roth will win if you assume your rate will be 25% at retirement which is what I believe mine will be, if not higher. You can see my comment below for some support arguments.

      But I’ve also created a spreadsheet I demonstrate to people showing a taxable account with long term gains vs roth and traditional. The numbers don’t lie, unless you are investing 100% of your traditional deduction and getting long term cap gains on it, the traditional falls well behind.

      Trust me, there’s a reason the government phases out Roth IRAs for high income earners. :)

  4. I have always questioned the reasoning of Roth IRAs since every older person I know pays no taxes. Most retired people will have income below their personal exemptions and deductions which makes the issue of taxable earnings from retirement accounts mute.

    • @Chris @ StockMonkeys.com, The only older people that are paying no taxes 1.) probably are living of SS 100% or 2.) never saved enough for retirement and have nothing to pay taxes on. Regardless they aren’t living out their golden years vacationing and eating fine food.

      A single person in retirement hits the 25% bracket at $36,251. If you have decent retirement ( > 2M ) you will hit this every year without even trying.

      Most people lack the discipline to reinvest the tax deduction anyways, when you factor that in the Roth blows traditional accounts away.

      I can reasonably assume taxes will be higher when I retire in 30 years, additionally I can assume SS will pay a fraction of what is pays now, inflation adjusted. Even if they keep the rate rates the same, inflation will make sure you are in a higher bracket.

      I’m maxing out my 401k Roth personally starting next quarter.

  5. Yard Lights says:

    I’m keeping mine in a traditional. Clearly I’m the expert you were hoping would weigh in!