Roth IRA versus Traditional IRA
One of best decisions virtually any saver can make to secure both needs and dreams for a prosperous retirement is to open an Individual Retirement Arrangement (IRA) that can be controlled. Whether the option to save and invest in an employer’s 401k plan is available or you don’t have the option to contribute to this account as a benefit at work, IRAs allow each person to take charge of his or her retirement. While everyone’s situation varies depending on many factors, both Traditional and Roth IRAs offer unique benefits to consider while putting away extra money for retirement.
What are IRAs?
Unlike a 401(k) or 403(b) plan sponsored by an individual’s workplace, IRAs are self-directed accounts that individuals with earned income can open to begin saving up to predetermined amounts for their spending needs in retirement.
Like an employer-sponsored 401(k) or 403(b) plan, investors can purchase mutual funds, index funds as well as individual stocks within these accounts which grow tax-advantaged. This means the government subsidizes your investing through tax policies to incentive saving for retirement.
Unlike a normal savings or brokerage account, the dividends that the stocks or funds pay will not be taxed or will be tax-deferred, so the account will reap the rewards of having 100% compounding interest without the government taxing the dividend payments. This allows your dividends to snowball into a continually larger sum. For both the Traditional and the Roth IRA, individuals are permitted to put away up to $6,000 each in 2019 ($7,000 if over age 50) which can be a great start to securing long-term future.
IRA Legislation
The earliest version of the IRA was introduced as part of the Employee Retirement Income Security Act of 1974 to incentivize savers put away money in tax-advantaged accounts for retirement.
In 1997, the Tax Relief Act of 1997 introduced the Roth option, which allows for individuals to put money away after paying taxes on their income. Instead of owing taxes on their distributions, investors will enjoy tax-free growth and distributions after age 59 ½.
Alternatively, Traditional IRAs allow for contributions to be deducted from current adjusted gross income on your tax return and grow tax-deferred. The gains will be taxed upon distribution in retirement as income. With the Traditional IRA contributions, individuals will enjoy the benefits of offsetting their taxes now and defer the tax payments later after their gains have compounded over the course of decades.
Traditional versus Roth Option
While either option represents better alternatives for saving for retirement than an individual brokerage account or other taxable account, the best account for total return will be based on an individual’s specific tax situation.
Not only must your individual tax scenario be assessed, you must also be able to predict where tax rates will be during your retirement years. While this may be all but impossible, a few key elements may be considered when deciding which option may be best.
Tax Rates
The main driver affecting the benefits of Traditional and Roth IRA’s are determined by an individual’s current and future effective tax rates.
Future tax laws including brackets, rates, and deductions are ultimately unpredictable over the long-term. Therefore, predicting and planning for the certainty of changes in the tax code can make deciding between the Roth or Traditional a difficult choice.
You should also consider how much income you will draw from your retirement accounts and spend in retirement. The amount you will need in retirement can vary wildly based on your Social Security benefit, pensions, inheritances, and other sources of wealth or income. Plus, your lifestyle spending needs and choices during retirement play an important role in determining how much income you will need.
Should tax brackets and rates, deductions, or other assumptions change over the course of an individual’s investing and retirement horizon, certain benefits of choosing a Traditional or Roth account could be impacted.
For instance, should Congress decide they need to raise tax revenue due to budget shortfalls, legislation could be introduced disallowing or limiting deductions for Traditional IRA contributions. Likewise, Congress could potentially limit the tax benefits of tax-free Roth IRA distributions.
While these scenarios remain unlikely and would require an act of Congress, the point remains that predicting legislative changes is nearly impossible when planning for retirement decades in advance.
More than likely, changes in tax brackets or rates will be implemented which would affect the value proposition from both Traditional and Roth IRAs.
For instance, should Congress raise the tax brackets at the point the individual retires, more of the income from the Traditional IRA would be taxed at higher levels. This would decreased the overall value of the balance because it would be subject to higher tax rates.
Alternatively, should tax rates at the point of retirement decreased, taking the tax deduction at higher tax rates earlier in life through the Traditional IRA would have been the most advantageous approach. Therefore, predicting where tax rates will be in 20, 30, or 40+ years and planning accordingly is impossible.
Benefits of the Roth 401(k) or Roth IRA Option
As discussed, the Roth option allows individuals to contribute after-tax money and invest with gains and dividends reinvested and distributed tax-free after the age of 59 1/2.
Essentially, the Roth option allows individuals to take the tax “hit” today and never worry about paying taxes on their earnings in the future. Unlike the Traditional 401(k) or IRA, investors are not allowed to claim a tax deduction for their contributions on the tax returns in the year the contributions are made. Depending upon the individual’s effective tax rate, this could result in thousands of dollars in additional tax expense each year that could have been deferred, freeing up cash flow to be spent or invested.
While current year tax deductions are not permitted, the Roth IRA’s benefits are derived in retirement when 100% of the balance can ultimately be withdrawn tax-free.
Roth IRA Example
While tax rates will change with legislative agendas and the contribution limits will rise as Congress adjusts the limits for inflation, consider an investor who contributed the current IRA limit of $6,000 at the historic market rate of return of 10% from age 25 to age 60.
Current Age: 25
Retirement Age: 60
Annual Contribution: $6,000
Average Annual Return: 10%
At age 60, the balance in his or her Roth IRA would be around $1,626,000.
Over the 35-year period, the individual contributed a total of $210,000. Therefore, capital appreciation and dividends comprise the balance of $1,416,000 which is due to the power of compounding interest over the 35-year period. Because the investor chose the Roth IRA, the total balance of the account is available without taxes.
Traditional Example
Let’s consider the same scenario above but for the Traditional option.
By contrast, in a Traditional IRA, the dividends and gains would have grown tax-deferred. However, the gains of $1,416,000 would be taxed as ordinary income upon distribution after the age of 59 ½. The amount of taxes would be based on the individual’s effective tax rate in retirement.
For comparison to the tax-free balance of the Roth IRA, assuming a 25% average ordinary income tax rate in the years of distributions, the adjusted balance on the Traditional IRA would be $1,272,000 which is $210,000 in contributions plus 75% of $1,416,000 in gains. This would account for the approximate taxes that would be owed on the distributions due to the capital appreciation.
Therefore, a retiree would have around $354,000 more if he or she had invested in the Roth IRA solely based on the timing of when tax payments were made.
By maxing out the Roth IRA versus a Traditional option, investors are essentially contributing around 25% more subconsciously due to the nature of when the tax obligation occurs.
Other Roth Benefits
An added benefit of the Roth IRA is the ability to withdraw contributions – but not gains – tax and penalty free before the age of 59 ½.
Traditional IRAs by contrast disallow withdrawals before 59 1/2, and individuals who do tap their accounts prior to 59 ½ will be taxed at their effective tax rate. They will also incur a costly 10% penalty. Therefore, withdrawing funds from a Traditional IRA prior to retirement is ill-advised as the penalties and taxes equate to borrowing money at around a 35% interest rate, assuming a 25% tax bracket.
While the ability to withdraw contributions from the Roth IRA can be beneficial in emergencies, the account should not be chosen just because of the withdrawal option as the money take out cannot be contributed back into the fund. This is because the total amount of contributions in a given year cannot exceed $6,000 in 2019 – even if money is pulled from the fund.
If the individual withdraws the contributions from their account because they were enticed by the ability to withdraw contributions, the opportunity cost of time in the market will greatly hamper overall returns. Ultimately, they would have been better off contributing to a Traditional option if the ability to withdraw contributions was too tempting.
Roth IRA Limitations
Another drawback of the Roth option that can be mitigated through tax planning is the limitation on higher income earners.
The IRS disallows contributions to a Roth IRA for individuals over a certain threshold. In 2019, there is a phase out of allowable contributions to a Roth IRA for earners between $122,000 and $137,000 for single filers and $193,000 and $203,000 for couples who are married filing jointly. Individuals or married individuals filing separately with an adjusted gross income greater than $137,000 and married individuals making more than $203,000 are not allowed to contribute directly to a Roth IRA.
However, by implementing a backdoor Roth IRA strategy, individuals and married filers can circumvent the restrictions by opening a Traditional, after-tax IRA, contributing to the account, and then converting the Traditional, after-tax account to a Roth.
By converting the Traditional, after-tax IRA to a Roth IRA, taxes would be owed on the capital gains (if any) in the year of conversion. However, if done immediately, there should be virtually no or little gains as the money did not have time to appreciate in the market.
After conversion, the account would now grow tax-free and withdrawals would be tax-free after 59 ½ years old. However, the backdoor option should be explored with a qualified professional to ensure there are no unplanned tax consequences.
Benefits of the Traditional 401(k) or Traditional IRA
As discussed, a Traditional IRA allows for a tax deduction in the year of contribution. However, the gains accumulated over the period are tax-deferred until they are ultimately withdrawn and then are taxed as ordinary income at the individual’s effective tax rate.
The example given in the Roth IRA section above discussed the difference in the adjusted balances of the Traditional IRA compared to the Roth IRA. However, this analysis did not incorporate the hypothetical tax savings on the contributions each year.
What if the savings from the tax deductions had been invested in the market?
Incorporating the growth assumptions of the tax savings should also be calculated as if they were invested in the market. This would fully incorporate the advantages of the Traditional to help determine its true value.
For illustrative purposes, consider the same investor who contributed $6,000 per year at the historic market rate of return of 10% from age 25 to age 60.
Let’s assume the investor made an average of $50,000 per year over the time period, took the 2019 standard deduction for a single filer of $12,000, resulting in taxable income or adjusted gross income of $38,000. Assume also that this individual had no other deductions available but wanted to take advantage of lowering their tax bill each year rather than paying the taxes up front and allowing their investment to grow tax-free in a Roth IRA.
Based solely on the standard deduction, the individual would have a federal tax obligation of $4,373 according to the IRS Tax Tables. Had the individual deducted Traditional IRA contributions of $6,000, their adjusted gross income would now total $32,000, resulting in a federal tax liability of around $3,653 or a tax savings of over $720 each year.
Had the $720 in savings each year been invested back into the stock market at a rate of 10% in an attempt to generate the after tax returns a Roth IRA would provide, the future value of the tax savings each year would be close to $195,000. Assuming a 15% capital gains tax rate, the after-tax amount earned from taking the tax deductions each year and investing the savings is approximately $166,000.
Therefore, the total adjusted value of the Traditional IRA would be around $1,438,000 versus the balance in the Roth IRA of $1,626,000 discussed above.
In this situation and based on the tax rates applied, the individual would have been better off investing their money in a Roth IRA because the amount saved by applying the tax deduction available in the Traditional IRA each year was not enough to offset the benefits of tax-free compounded growth and distributions of the Roth IRA.
What about the tax savings for high-income earners?
However, as the investor’s adjusted gross income rises due to higher salary assumptions, the Traditional IRA becomes advantageous because of the increase in the effective tax rate. The tax deduction from the Traditional results in a greater amount saved today, allowing the time for the tax savings to compound.
To illustrate how a higher effective tax rate would impact the value of the Traditional IRA tax savings, assume an individual’s average salary over 35 years went from $50,000 to $200,000.
Assuming the standard deduction of $12,000 was taken, the individual’s adjusted gross income would be $188,000, resulting in an effective tax rate of around 21%. Consequently, the tax savings would be greater had the deduction been taken for the Traditional IRA contribution – around $1,920 in tax savings versus $720 for the individual making $50,000 under the same assumptions.
Had the individual making a salary of $200,000 and contributing to the Traditional IRA invested the $1,920 over a 35-year period at the market’s rate of return of 10%, they would have around $520,000 or $442,000 after tax, assuming a 15% capital gains tax.
Adding this amount to the tax-adjusted balance of $1,272,000 from reducing the approximate amount of taxes from the Traditional IRA balance previously discussed, the individual with an adjusted gross income of $188,000 would have a tax-adjusted nest egg of $1,714,000 versus the amount in the Roth of $1,626,000.
In this hypothetical example, because the high-income earner had a higher effective tax rate which resulted in greater tax savings from taking the deduction, utilizing the Traditional IRA resulted in a greater amount even after adjusting for taxes that need to be paid on the balance.
Consider the Psychological and Behavioral Aspects
While attempting to find the optimal account and amount to invest for retirement may not be straight-forward, individuals looking to open a Roth or Traditional IRA must also consider the psychological aspect of these scenarios.
While the theory of assuming any extra cash from the tax savings from the Traditional option would be invested, taking the tax savings and investing the difference becomes difficult to implement with other obligations and spending desires. Ultimately, while the math may dictate an individual earning $200,000 should take the tax deduction today, save and invest the difference, diligently following the formula becomes much more difficult in reality.
Therefore, the $88,000 more in the tax adjusted Traditional IRA may not be worth the hassle and additional risk of not following through to optimize their portfolio over the 35 year period.
By contributing and maxing out a Roth account, you limit the margin for error. With this account, you never have to worry about investing the difference in tax savings to make up the difference. With each contribution, you are effectively contributing more than you realize because of the tax benefits.
What’s the best choice?
Choosing either a Roth or Traditional IRA may not be the most straight forward decision as so many factors and variables influence which account would have resulted in the highest value over the period.
However, do not over-analyze and stress over the unknown variables when trying to decide which account is best. Often, investors delay in opening an IRA because they may not understand the differences or know which is “best” for them. Just getting started and taking the steps to contribute should be the primary goal as both options offer a great way to put money away and invest for long-term retirement goals.
As a general rule, individuals in lower tax brackets with longer time horizons for their contributions to compound should prioritize the Roth IRA. The tax deductions today are less meaningful compared to the tax-free withdrawals in retirement.
Conversely, individuals with higher adjusted gross incomes and higher effective tax rates may wish to contribute to a Traditional IRA. However, taking the deduction today and investing the tax savings is paramount to compete with the Roth option. Even for these higher income earners, the benefits of taking the tax deduction may not be worth the extra hassle of contributing the tax savings to an account outside of their IRAs.