Which is the best choice
for clients when it comes to retirement savings: a traditional IRA or a Roth
IRA? This question has been pondered countless times since the Roth was
introduced in the Taxpayer Relief Act of 1997. Proponents argue that a Roth IRA
is better for individuals with a longer time horizon, because interest
comprises a larger portion of an account’s total value as the years progress.
In addition, qualified withdrawals from a Roth IRA are tax-free.
Therefore,
since interest is a larger component of an account’s value over longer periods,
the tax savings for younger individuals is greater with the Roth. This is
precisely what I used to think, that is, until I ran the numbers. Let’s take a
look.
Assumptions
Here
are the assumptions used in this analysis:
1)
Contributions: $10,000 (beginning of year)
2)
Contribution period: Years 1-25
3)
Withdrawals (after tax): $10,000
4)
Withdrawal period: Years 26-50
5)
Average annual return: 8.0%
6)
Federal income tax rate during contribution/withdrawal period: 35%/25%
7)
State income tax rate during contribution/withdrawal period: 6%/4%
8)
Combined tax rate during contribution/withdrawal period: 38.9%/28% (state
income tax is deductible on federal tax return)
Note: The rules and/or
penalties pertaining to contribution limits, early withdrawals (pre age 59½),
and mandatory withdrawals (RMD at age 70½), have been ignored. The table below
contains additional details on the contribution and withdrawal
methodology.
Assume
each individual begins with $10,000 in earned income. Contributions to a
traditional IRA are pre-tax, whereas the Roth IRA investor must pay taxes prior
to investing. If we contributed the same amount to each, the Roth IRA investor
would have to earn $16,367 to have $10,000 to invest after paying taxes.
Although
the traditional IRA has the tax advantage during the contribution phase, when
withdrawals begin, the Roth IRA has the advantage, since qualified withdrawals
from a Roth are tax free. This seemed to be the fairest way to compare the two.
See table below for more.
The
Results
The
results of the analysis are contained in the graph below.
At the
end of the contribution period (25 years), the value of the traditional IRA is
38.9% greater than the value of the Roth. At the end of year 50, even though
annual withdrawals from the traditional IRA were increased to $13,889 to net
$10,000 after tax, its value is still 41.4% greater than the Roth IRA.
On the
surface, this may seem counterintuitive. The difference is due to the amount of
interest earned in each IRA during the withdrawal period. Because the
traditional IRA’s value is much larger, even after increasing withdrawals to
$13,889 to net $10,000 after-tax, its growth is still slightly better.
The analysis also included a scenario where
federal and state tax rates were the same in all years (25%/4%). Contributions
to the Roth were $7,200 per year ($10,000 minus combined tax rate). The traditional
IRA’s value was 28% greater than the value of the Roth throughout the
withdrawal period.
The analysis was run assuming there were no taxes
during the contribution period, thus allowing the full $10,000 contribution to
each IRA. Since their values would be identical at the end of the contribution
period, the difference would occur during the withdrawal phase.
After the first year of
withdrawal (year 26), the Roth IRA’s value was 0.5% greater than the
traditional IRA. This margin increased to 6.5% by the end of the analysis (year
50).
Here
are a few closing thoughts. A shorter contribution period favors the
traditional IRA. Higher future tax rates favor the Roth IRA. Since the tax
benefits of the traditional IRA are realized during the contribution period and
the Roth’s tax benefit is realized during the withdrawal period, relative tax
rates for both periods are a critical element in this decision.
To
render the best possible advice, it is best to run the numbers on a per case
basis.
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