The Knockout Punch in the IRA Grudge Match
There’s an ongoing battle in the financial realm pitting the Roth IRA against its older cousin, the Traditional IRA. Most of the debate, however, is rendered irrelevant because it doesn’t consider the Traditional IRA’s fatal flaw.
Tale of the Tape:
The IRA debate is almost entirely about taxes. As long as you meet certain income requirements, Traditional IRAs offer you the opportunity to claim a tax deduction up to the maximum contribution limits in the tax year for which the contribution is made, but every dollar that is ever distributed from the IRA will be taxed as ordinary income in the year of distribution.
The Roth IRA offers an inverse tax privilege. While there is no deduction for the contribution, qualified distributions of both principal and growth are tax-free.
As the predominant logic goes, then, if you expect to be in a higher tax bracket in retirement than you are today, contribute to a Roth IRA. If, instead, you are likely to be in a lower tax bracket in retirement, contribute to a Traditional IRA.
By this logic alone, if your tax bracket would never change, there’s virtually no difference between the two investment options. But, like many personal finance one-liners and rules-of-thumb, this one falls woefully short of giving you the whole story.
The Knockout Punch:
Please consider this: Which is more valuable—a dollar in a Roth IRA or a dollar in a Traditional IRA?
As long as you’re expected to pay taxes the answer to this question is always—100% of the time—the dollar in the Roth. This is because the Roth allows you (and your heirs) to extract qualified distributions free of taxes. The dollar in the Traditional IRA, on the other hand, is subject to taxation whenever you (or your heirs) remove it. So, if you’re in a 25% tax bracket, your Traditional IRA dollar is actually only worth 75 cents. The higher your tax bracket, the less your Traditional dollar is worth.
This commentary originally appeared May 30 on Forbes.com
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