Roth IRA: The more American option?

I mentioned briefly in my last post that I started off the New Year by maxing out my IRA ($5,500 max contribution this year, up $500 from last year).  I have every intention of maxing out my IRA each and every year, and it feels great to have met this goal for 2013 already.  I’m also going to take a moment to brag (and marvel & feel happy) that … I now have $36,570 invested.  That’s pretty awesome – about 16K of that is in my IRA (individual retirement account), the rest in my 401K (plan I access through my employer). 

The differences between a traditional and Roth IRA are pretty straight-forward: with the traditional account, you put in pre-tax dollars and pay taxes as you withdraw them in retirement, whereas with a Roth you put in money after it has already been taxed, then pay no taxes on the original money you put in (or the appreciation your money has earned) when you withdraw.  [Disclaimer: there are a few other nuances, such as income limitations.]  Opinion is divided as to which option is the best, with general consensus being that as a young person, you’re likely better off with a Roth.

The big unknown in the equation is taxes:  if you are young and plan to climb the corporate ladder, your income likely will go up as you age, as will your taxes.  I’m also of the opinion that taxes have nowhere to go but up, and expect them to increase rather than decrease over time.  As the goal is to minimize taxes (and keep as much of your money as possible), conventional wisdom dictates that for a young person it’s better to get a Roth, and pay taxes now rather than later.  The point may be moot, however, if you no longer are working by the point that you withdraw money – in that case, you will have very little income and subsequently lower taxes.  Now, who knows how much taxes will go up, and how your salary (& tax bracket) will change?

A model, no matter how brilliant and thoughtful, is useless if it’s based on faulty assumptions, or marginally useful if it’s built on assumptions with a low probability of being correct.  I know that money is complicated and that we’re not robots, so our financial decisions are not simply mathematical calculations.  I love thinking about money because to me it designates freedom – if you have money, you have more choices.  And especially if you have enough money to not need a job to pay for your needs, you really have a whole lot of choices.  Designing you life with the purpose of having many options open to you is the way to go – it will likely to take many years of working and building skills and saving money before you have the leverage to negotiate for, or even recognize, a dream job.  So you need to carefully construct opportunity in the meantime: working hard, reading and learning a lot, and in college picking a versatile degree (such as engineering) or double-majoring.

Which brings me to the IRA – I have no clue what will happen to taxes in the future.  I also can’t predict future earnings.  But I want to have options, and I want to feel in control.  For that reason, I pay my taxes now so that I know exactly what I’ll be paying on my returns in the future – nada!  With a traditional IRA, you cannot withdraw money before retirement age without a heavy penalty, and then you are required to withdraw certain amounts upon retirement (Uncle Sam wants to tax you and get moneys).  That’s right – you have to take out money in retirement. With a Roth, there are no required minimum withdrawals, so passing on your money to your kids or grandkids is much easier.  The other great thing about a Roth is that since you’ve already paid taxes, you can take out the principal (the money you’ve paid in, but not the appreciation) at any point, with no penalty.  This means that if you have a medical bill, want to put a down payment on a house, or have another emergency, you can use your money before retirement.

The other thing that’s brilliant about a Roth – your money is clearly earmarked for retirement, and if you mentally prime yourself to think that way, it might be hard to take out money earlier for other things, and thus easy to keep it saved for retirement.  Mental accounting (mentally designated funds for various causes) can be very powerful.  It’s easier to spend your $500 bonus than $500 from your regular paycheck.  And many people have an ‘emergency’ fund sitting in a savings account generating no interest and losing value gradually due to inflation, while paying 20% or more in interest on their credit cards.  Logically, that’s not a smart idea as you would be better off paying down the credit card balance, but emotionally it feels comforting that you have savings should you need them.  My goal is to keep the money in my IRA for a long time – but it’s certainly comforting that I have ultimate control, and could use it for any number of things.  I certainly don’t want to be told by the government how much or when I can withdraw money, either.

What about you – do you have an IRA?  Which do you prefer, a Roth or traditional?  How did you choose between them?