Americans who have traditional IRAs tend to differ from the people who own Roth IRAs. And understanding those differences can help you decide which one of those retirement accounts should be better for you.
For one thing, investors who own Roth IRAs tend to be younger than owners of traditional IRAs.
The median age of Roth IRA owners is 48, nearly a decade younger than the 56-year-old median age of traditional IRA owners, according to the Investment Company Institute (ICI),an industry group that compiles facts and figures about IRAs.
Further, 31% of Roth IRA owners are younger than 40. In contrast, only 16% of traditional IRA owners are that young.
Why do Roth IRA owners tend to be younger?
- Tax rules. The mainreason Roth owners are younger isbecause of differences in tax rules that governthe two types of IRAs.
Unlike traditional IRA owners, Roth IRA owners do not get a tax deduction for contributions to their accounts. They earn a paycheck at work, pay income tax on that money and then stash some of that money into a Roth IRA. The money grows tax-free. And account holdersare allowed to withdraw earnings tax-free after five years and age 59-1/2. (They can withdraw contributions tax-free at any time.)
In contrast, traditional IRA owners do get an upfront tax deduction on their contributions. Investments inside their account grow year by year without being taxed. But when the money is withdrawn, it is taxed as ordinary income. The tax hits all of their withdrawals, whether it is the money that was originally contributed or earnings on those contributions.
As a result, workerswho are years or even decades away from retirement choose Roth IRAs so they can pay tax on their income when they are young and in a low tax bracket. Their strategy aims to avoid paying income tax on IRA money when they are older because they expect to be richer and in the same or higher tax bracket then, even if they are retired.
Their strategy is also a hedge against the risk that politicians might well raise tax rates and brackets in the future. "People understand that tax rates may go up by the time they're in retirement," saidSarah Holden, the ICI's senior director of retirement and investor research.
Even if a Roth owners' tax bracket stays the same in retirement, he should come out ahead.Ken Mahoney, president of Mahoney Asset Management, said, "Absolutely, Roth's are better suited for individuals with longer-term retirement horizons. The longer term horizon affords anindividual the opportunity to invest their after-tax dollars and captured growth that will not be taxed upon retirement and withdrawals. The thinking isgrowth long-term should outpace any short-term tax benefits that are only earned in the year the contributions are made."
- Time.The amount of time you have before needing to withdraw money from your account is another factor.
Remember, you can withdraw earnings tax-free only after five years and age 59-1/2. Older workers often need their money sooner than five years or more from now, so they're forced to opt for a traditional IRA.
Beware Of This Pitfall
You don't get any tax deduction for contributions to a Roth IRA. Since you are paying tax on the income that you draw your contribution from,you're left with less take-home pay. To compensate for having less money in their pockets, some workers — likely a small percentage — don't contribute as much to their retirement account as they would with a traditional IRA.
Suppose such a worker is in the 25% bracket. And let's say this worker already feels stretched to the limit, already barely able to afford retirement plan contributions. That worker might decide that since he is not getting an upfront tax deduction, he can only afford a $750 Roth contribution instead of the $1,000 contribution he used to make to his traditional IRA.
That would be a mistake. "(That)could leave them less prepared (once they eventually retire) due to those lower savings rates," said Joel Dickson, head of investment research & development at Vanguard Investment Strategy Group.
More Stocks
A second difference between Roth and traditional IRA owners is that Roth IRA owners tend to invest more aggressively. Roth owners have nearly 80% of their assets — 78.6% to be exact— invested in stocks, stock mutual funds and stock ETFs in their accounts. That stock exposure includes stocks in balanced funds, which hold both stocks and bonds.
In contrast, traditional IRA owners have a still decent but smaller 65.1% weighting in stocks and stock funds.
Why do Roth IRA owners bet more on stocks? Since many are younger than traditional IRA owners, they likely know they have more time to rebound from any short-term market declines.
Help For Heirs
Yet another reason that investors of any age elect to go the Roth route is that Roth IRAs can be passed to a named beneficiary at the owner's death. Financial advisor Dan Yu of EisnerAmper points out that beneficiaries inherit the original account owner's immunity from income tax. "(They) can stretch the distributions over their lifetime with no income taxes," he said. This gives them an extended period of tax-exempt growth, which is a very nice perk, he says.
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