Why all IRA choices aren’t created equal

Planning for retirement isn’t easy, especially for those who lack company-sponsored 401(k) plans or pensions. Not only do you need to have the self-discipline to set aside money, but there’s often the confusing choice of which IRA vehicle to use: a Roth plan or a traditional IRA.

For many, the decision between picking a Roth IRA or a traditional IRA should be clear, notes Stuart Ritter, vice president of T. Rowe Price Investment Services. It’s often based on a worker’s age and how he or she expects their tax rate to change by the time they retire. Granted, the latter can be tough to predict, but here’s a simple question: Do you want to maintain the same lifestyle? Then plan for a similar tax rate.

“The choice is about which one gives you more income in retirement,” Ritter told CBS MoneyWatch. “For most people, the Roth IRA gives you more spendable income in retirement, as well as a host of other flexible choices.”

The basic difference between the two plans boils down to this: While contributions to a Roth IRA aren’t tax deductible, withdrawals are tax-free, while the traditional IRA offers an initial tax break, but withdrawals are taxed as ordinary income.

A study from T. Rowe Price found that for most workers, the Roth IRA would lead to more spendable income in retirement. Take a 30-year-old worker who expects to have the same tax rate in retirement. Her spendable income will be 17 percent higher with a Roth than with a traditional IRA.

So, who wouldn’t stand to benefit from a Roth IRA? Generally, workers who are nearing retirement and whose tax rate will be reduced once they stop working, the study found.

Younger workers are getting the message about the Roth IRA’s benefits, Ritter noted. One reason that younger employees may find the plans more appealing is that they might start out saving while in a lower tax bracket, which means some of their retirement assets will have been taxed at a lower rate than when they’re older and earning more.

Since Roth IRAs were created in 1997 as part of the Taxpayer Relief Act, they’ve seen huge growth in number of participants. Last year, more than 19 million U.S. households held Roth IRAs, compared with 36 million households with traditional IRAs, according to the Investment Company Institute.

Yet, one troubling statistic is the low rate of participation, with only 15 percent of U.S. households making contributions to any type of IRA in 2012, the ICI study found. The growth of IRAs is largely due to investment returns and rollovers from employer-sponsored retirement plans.

That’s jibes with the results of a new poll from CBS News, which found that more than 80 percent of people making less than $50,000 a year said it’s hard to both put away money for retirement and pay the bills. And with only half of private-sector workers having access to a retirement plan at work, it’s incumbent on those employees to sock away their own retirement funds.

That may explain why the median retirement account balance for all working-age households in the U.S. is just $3,000.

To prepare for retirement, Americans should plan on setting aside 15 percent of their income, whether through their employer-sponsored plan, an IRA or, lastly, a taxable account, Ritter said. Workers with a 401(k), for instance, can also invest money in an IRA, subject to income limits, he noted.

To make saving for retirement as easy as possible, workers should set up automatic monthly contributions to an IRA, he said. “That sets it on autopilot,” Ritter added. “If you say, ‘I’ll see what I have in my tax refund, or at year-end,’ that makes it harder than it needs to be.”