Roth versus Traditional IRA – the hidden assumption

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It’s almost tax day, and as usual we are seeing a lot of articles about whether people should use a Traditional IRA or a Roth IRA.  The difference between the two options is when you pay taxes.  When you use a traditional IRA, you get a tax deduction today and all the earnings in the account grow tax free until you take the money out.  When you withdraw the money, it is taxed as ordinary income.  With a Roth IRA, you pay income taxes today based on ordinary income tax rates, but all future earnings are tax free.  There are also no required annual distributions after you turn 70.5.

There are many internet calculators available to help you decide which account is better for you, given a set of assumptions.  However, one of the most critical assumptions is very rarely discussed…will there still be an income-based tax when you want to take the money out of the account and what will that rate be.

When Steve Forbes first started talking about a flat tax 10+ years ago, few people gave it much of a thought.  However, in both the Republican primary and the “Ryan Budget”, the focus was on a flatter tax system with 2 tax rates, both of which are lower than today’s rates for the same level of income.  In addition, there has been talk about a national sales tax (remember 9-9-9??) or Value Added Tax (VAT) which is used in many countries around the world.  I don’t want to get into the politics or economics of this decision, but as an investor trying to save for the future these are important things for you to consider.

For someone saving for retirement in a Roth IRA, this means that they would  pay taxes at a higher rate today than they would have paid in the future if these changes are made.  If we move to a sales tax or VAT, you may have paid income tax on the money initially, then need to pay a national sales tax when you use it.

The question of which type of IRA is better for you depends on the assumptions you make about the future.  The important thing to realize is that there are more assumptions that go into this analysis than just our current tax rates.

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