Traditional IRA vs. Roth, Part II
What’s better, a Traditional IRA or a Roth IRA? In my last article, we discussed why one is not necessarily better than the other. They just have different features. I wrapped it up with this paragraph:
What do you think benefits you more from a tax standpoint: A tax deduction now in a Traditional IRA, or tax free growth in a Roth? The answer may surprise you. This aspect will be the topic for the next newsletter.
This question is what we will cover today.
Many advisors will tell you that because of the amazing effect of compound interest, your earnings will vastly outweigh your contributions come retirement. Why, they ask, would you want to pay taxes on your earnings, when you could just get away with paying taxes on your contributions? Seems logical, right? Let’s look at two examples.
Ron, age 40, contributes $3,000 to a Traditional IRA each year, and continues this until age 65. He receives a $450 tax deduction each year since he’s in the 15 percent tax bracket. The account grows at an average rate of seven percent annually, and at age 65, is worth $203,000. At this point, he has contributed a total of $75,000 to his IRA. That means that the earnings total $128,000.
This is where a lot of people get led astray. They assume that Ron will withdraw all the money from his IRA when he retires. Thus, Ron will be taxed on the total lump sum of $203,000. That of course, would be a huge tax bill. The $450 per year tax savings he received when they contributed would be miniscule compared to it.
If Ron did this, then the Roth IRA would be the better deal hands down. But, he’s not going to. Why? Because he is only going to pull out enough money to meet his annual spending needs. He will leave the balance in his IRA to accumulate tax deferred.
For Ron, this means withdrawing six percent of his account balance at age 66, and increasing it by three percent annually to keep up with inflation. So the first year, he takes out $12,180. He is still in the 15 percent tax bracket, so his first year tax bill amounts to $1,827. He passes away at age 90 after receiving his annual withdrawal. His final tax bill (still at 15%) amounts to $3,714.
Note: In many cases, I have clients able to take more than this out of their IRAs each year, and not pay a dime of tax. They get the tax deduction when they contribute, and then they pull it out tax free. Literally, they are able to have their cake and eat it too! That’s a topic for another day.
Ralph, age 40 contributes $2,550 to a Roth IRA each year, and continues this until age 65. He would contribute $3,000, but since he’s in the 15 percent tax bracket, this Roth contribution costs him $450 in taxes. The account grows at an average rate of 7 percent annually, so by age 65 he has accumulated $172,575.
He has contributed a total of $63,750 to his account, so his earnings portion is $108,825. He also begins taking six percent out of his account each year, adjusted for three percent inflation. His first year’s distribution is $10,355, and of course, it is tax free. Like Ron, he also passes away at age 90, but unlike him, he paid no income taxes on his distributions.
So let’s zero in on the tax situation for these two men.
The total amount of tax deductions Ron received for his Traditional IRA contributions was $11,250. The total amount of taxes he paid on his IRA distributions was $66,611.
The total amount of taxes Ralph paid on his Roth IRA contributions amounted to $11,250.
At first glance, it would seem that Ralph made out better. But did he really? These totals ignore two very important factors:
- The time value of money
- Inflation
First is the time value of money. If I came to you and offered you $100, it would no doubt make you happy. What if I then asked: “Would you prefer I give this money to you now, or 25 years from now? You would say “Duh, I want the money now.” Why? All else being equal, getting money now is better than getting money later.
The second issue is inflation. $100 now is worth more than $100 twenty-five years from now because the purchasing power of our dollars will go down.
The point I’m trying to make is that getting a $450 tax deduction now and over the next 25 years has some value, even though you then have to pay taxes over the subsequent 25 years.
In finance, the way we take these factors into consideration is to use a calculation called net present value. Basically, I take the amount of all future inflows (tax deductions) and outlays (tax liabilities) discounted at a certain interest rate, and bring it to back to a single value in current dollar terms. The interest rate that is generally used would be the rate of return these men received on their investments, or seven percent.
The net present value of Ron’s Traditional IRA when it comes to taxes is $75. That means that even though he paid much more in taxes than he received in deductions, the deductions were still slightly better for him because he received them first. A politician might say that Ron’s Traditional IRA is revenue neutral.
The net present value of Ralph’s Roth IRA on the other hand is negative $850. His tax payments up front hurt him.
Surprisingly, in these examples (and many others I’ve run), the Traditional IRA comes out ahead of the Roth from a tax standpoint!
I am not saying that a Traditional IRA is better. What I am saying is that choosing a Roth over a Traditional is far from being a no-brainer.
A Roth IRA may be better for one person, and the Traditional IRA may be better for another. It all depends on your unique circumstances and the assumptions you use.
Thoughtful planning can help you decide. For many folks, perhaps the wisest course of action is to diversify—own both.
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