Traditional IRA or Roth IRA – Which one should you contribute to?

Everyone has an opinion but nobody has a definitive answer.

Until now.

This article shows that there is a clear winner for people who plan to retire early.

And if you choose the right option, you could accumulate an extra $100,000 over the course of your lifetime!

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

Tax-Free-Contribution accounts are the most-common type and have the following characteristics:

Funded with pre-tax (i.e. untaxed) dollars

Grow tax free

Taxed at withdrawal

Here’s a simple illustration showing when your money gets taxed:

Traditional IRAs, 401(k)s, and 403(b)s are all examples of this type of retirement account.

Tax-Free-Withdrawal Accounts

Tax-Free-Withdrawal accounts, on the other hand, are:

Funded with after-tax dollars

Grow tax free

Allow tax-free withdrawals

Roth IRAs and Roth 401(k)s are examples of this type of retirement account.

Taxable Accounts

Both options are good because they provide some tax benefits that allow your investments to grow faster than they would if simply invested in a normal taxable account.

Here’s what a taxable account looks like:

Not only is your money taxed before it enters the taxable account, your investment growth is also taxed along the way.

Bonus: To keep track of all of your accounts, To keep track of all of your accounts, click here to download a free copy of the spreadsheet I used on my own journey to financial independence and early retirement!

Choosing Between a Roth IRA and a Traditional IRA

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 tax when you withdraw the money and if you go with a Roth IRA, you pay the tax up front.

Roth IRA Conversion Ladder

Today, I’m going to show you how to get the best of both worlds – tax-free contributions, tax-free growth, AND tax-free withdrawals!

Here’s the strategy:

Step 1: Contribute to a Traditional IRA During Your Working Years

While you are working, your tax rate will likely be higher than it will be after FI so shield as much of your income from the taxman as possible by contributing to a Traditional IRA.

Step 2: Slowly Convert Traditional IRA to Roth IRA

Once you begin your early retirement, you’ll have less taxable income than you did when you were working so use this period to convert your Traditional IRA to a Roth IRA.

You didn’t pay tax on the money when you contributed to your Traditional IRA so you have to pay tax when you convert to a Roth. Your income will be lower after you retire though so you’ll likely pay very little tax on the conversion. In fact, if you convert an amount equal to your deductions, exemptions, and credits every year (and assuming you have no other ordinary income), you could execute these conversions without paying any tax at all!

Step 3: Enjoy Your Completely Tax Free Retirement Money

After converting your entire Traditional IRA to a Roth IRA during your early retirement, you can withdraw that money from the Roth tax free!

Note: To avoid paying a 10% early-withdrawal penalty, you have to wait five years after the conversion (or until you turn 59.5, if that’s sooner) to withdraw the converted funds from the Roth.

How is This Possible?

This strategy is referred to as a Roth IRA Conversion Ladder and you may be wondering why everyone doesn’t do this.

Well, there are a few reasons this strategy only makes sense for early retirees…

Low Income and Living Costs

Most early retirees live on a modest amount of income from tax-efficient sources like long-term capital gains and dividends (which are taxed at 0% when you’re in the 15% tax bracket or below). This means they can use their tax-free space (i.e. deductions and exemptions) for things like Roth conversions.

Long Conversion Timeframe

Conversions from a Traditional IRA to a Roth IRA are taxed as ordinary income so it’s beneficial to spread the conversion over a large timeframe. That way, you don’t increase your taxable income too much in any given year.

Since most people work full time until they reach retirement age, they never have periods of lower income to do these conversions cheaply. Any amount converted while working would increase the amount of tax they have to pay at their marginal tax rate and wouldn’t be worthwhile.

Here’s a typical income/spending graph for someone on the standard retirement track:

As you can see, income is high (and growing) from age 20 to age 60 so there aren’t any good opportunities to do the conversion.

Early retirees, however, can use their low-income years during early retirement to gradually perform the conversion, tax free.

Here’s a typical income/spending graph for an early retiree:

Let’s see how this entire strategy could play out…

To save on taxes during your working career (i.e. when your income is high), you contribute to a Traditional IRA:

When your income drops during early retirement, you start rolling over that money to a Roth IRA:

Five years after you begin the conversions, you begin withdrawing money from your Roth, penalty free:

The Power of this Strategy

A simple example will highlight how much money this strategy 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 leftover money 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 are the investors’ normal taxable accounts, the dashed lines are the investors’ Roth IRA accounts, and the dotted line is Investor B’s Traditional IRA account.

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.

Since Investor B converts less than his standard deductions and exemptions each year, he avoids paying taxes on the conversion and ends up having exactly the same amount of money in his Roth IRA as Investor A does when they reach standard retirement age.

What you’ll notice though is that Investor B actually has quite a bit more in his taxable account. Contributing to a Traditional IRA reduced his taxes when he was working so he had more money to invest in the taxable account during his 30s. As a result, he ends 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 can result in a six-figure difference in retirement savings!

Why Stop There?

In this article, I’ve shown how a Traditional IRA can become a completely tax-free retirement vehicle when combined with a Roth IRA.

In the Ultimate Retirement Account article, I described how an HSA can also be used as a completely tax-free retirement account.

What about the other major retirement accounts like the 401(k) and 403(b)?

Yes, they too can potentially become completely tax free!

Tax-Free 401(k)

Since you can easily convert your 401(k)/403(b) to a Traditional IRA after you separate from your employer, it is just one extra step to get your 401(k)/403(b) money into a Roth IRA using the tax-free method described above.

What if You Earn Too Little or Too Much?

The upfront tax deductions provided by traditional retirement accounts are the reason this strategy is so beneficial.

If your income is low enough that you don’t have to pay taxes anyway, additional tax deductions aren’t going to help you so you should just put your money into a Roth. That way, you can withdraw it later, tax free (when you could be in a higher tax bracket).

Conversely, if you earn too much to get the Traditional IRA tax deductions, you’d also be better off contributing to a Roth, a Mega Backdoor Roth, or simply a taxable account.

Here are the 2018 income limits for obtaining Traditional IRA tax deductions:

Accessing Retirement Accounts Early

Many future early retirees worry about putting too much money into retirement accounts because they don’t want their money locked up until standard retirement age.

As this article has shown, the Roth IRA Conversion Ladder is a great way to access that money early but here are even more ways to access retirement account funds before standard retirement age.

Traditional vs Roth IRA

So there you have it.

Finally a definitive answer to the Roth IRA vs Traditional IRA debate.

For future early retirees, the clear winner is the Traditional IRA.

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?

This post was originally published on February 12, 2013 but was updated on March 21, 2017

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