Retirement Accounts

The Roth IRA Advantage

Conventional wisdom is that your choice between a traditional pre-tax retirement account and an after-tax Roth is irrelevant as long as your tax rate never changes.  As a reminder, both a traditional IRA and Roth IRA are tax-deferred retirement accounts, and could expose you to early withdrawal penalties if distributions are taken before age 59.5.

The traditional IRA tax break comes while contributing to the account.  You may be able to deduct the contributions from your tax return for immediate tax savings.  The Roth IRA is funded with money that has already been taxed.  While no deduction is given for contributing to a Roth IRA, the balance can be withdrawn tax-free if you are over 59.5 years old and have had a Roth IRA for at least 5 years.

Is one account better than the other, or would they truly both be equal if tax rates do not change for you?

If you contribute $5,500 per year to either account and are able to grow the assets at 6% annually then either account will have a balance of $434,820.02 after 30 years (tables below).  Since the traditional IRA would all be taxable and the Roth IRA balance would all be tax free, isn’t it a no-brainer that the Roth IRA is better?  Assuming an average tax rate of 22%, your after-tax balance in the traditional IRA is $339,159.62, about $95,660.41 less than the Roth IRA.

I left out a big part of the equation.  If that $5,500 is contributed to a traditional IRA every year, you get immediate tax savings which theoretically frees up more money for you to invest in a separate account.

Assuming you were receiving that $5,500 deduction for 30 years while in a 22% tax bracket, you would have saved $1,210 per year in federal taxes for a total savings of $36,300 over the 30 years.  That closes the gap of the Roth advantage from $95,660.41 to $59,360.41 (Table 1), but it doesn’t eliminate it.  What gives?

Well if you took the $1,210 of tax savings each year from your traditional IRA contribution and put it into a separate account earning the same 6% growth rate, your total after 30 years is exactly $95,660.41 (the exact same size as the original difference)!  That’s not a coincidence though. (Table 2)

From my experience, most people that contribute to pre-tax retirement accounts (like traditional IRAs) for immediate tax savings do not invest that tax savings into a separate account, they spend it.  In my opinion, this means they would be better off deferring into a Roth IRA instead.

But what if your tax rate does indeed drop from your working years to your retirement years?  Let’s say you defer into a traditional IRA and get tax savings at the 22% rate, and when you retire you withdraw the money and pay an average federal tax of 12%.

Now in the traditional IRA your after-tax balance would be $52,178.40 less than the Roth (as opposed to the $95,660.41 above), but you would have saved $36,300 in taxes during the 30 years of contributions still.  So unless you actually did reinvest your tax savings from traditional IRA contributions into a separate account, even with your average tax rate falling 10 percentage points, the Roth IRA balance comes out ahead by $15,878.40 (52,178.40 – 36,300)! (Table 3)

If you did reinvest your tax savings into a separate account earning the same return, and the rates dropped from 22% to 12% between your working life and retired life, then the traditional IRA comes out ahead by $43,482.01. (Table 4)

The bottom line is, one of the main factors to be considered in the Roth versus Traditional IRA debate (assuming you are eligible for either account) should be based on whether or not you intend to reinvest your immediate tax savings into a separate account, but you rarely see this aspect of the debate discussed anywhere.

 (Table 1)    Tax Rate Never Changes and tax savings is not invested separately
Traditional IRA Roth IRA
Annual Investment  $      5,500.00  $       5,500.00
Number of years 30 30
Investment Growth Rate 6.00% 6.00%
Working Life Tax Rate 22.00% 22.00%
Retired Life Tax Rate 22.00% 22.00%
Final Pre-Tax Balance  $  434,820.02  $   434,820.02
After-Tax Balance  $  339,159.62  $   434,820.02
Tax Savings during contribution phase  $    36,300.00  $                  –
After-Tax Balance Plus Tax Savings  $  375,459.62  $   434,820.02
Roth IRA Advantage $59,360.41

 

  (Table 2) Tax Rate Never Changes and tax savings is invested annually in a separate account
Traditional IRA Roth IRA
Annual Investment  $      5,500.00  $       5,500.00
Number of years 30 30
Investment Growth Rate 6.00% 6.00%
Working Life Tax Rate 22.00% 22.00%
Retired Life Tax Rate 22.00% 22.00%
Final Pre-Tax Balance  $  434,820.02  $   434,820.02
After-Tax Balance  $  339,159.62  $   434,820.02
Tax Savings during contribution phase plus growth $95,660.41  $                  –
After-Tax Balance + Tax Savings + Growth of Tax Savings  $  434,820.02  $   434,820.02
Roth IRA Advantage  $                              0.00

 

 (Table 3)  Tax Rate Decreases from 22% to 12% and tax savings is not invested separately
Traditional IRA Roth IRA
Annual Investment  $      5,500.00  $       5,500.00
Number of years 30 30
Investment Growth Rate 6.00% 6.00%
Working Life Tax Rate 22.00% 22.00%
Retired Life Tax Rate 12.00% 12.00%
Final Pre-Tax Balance  $  434,820.02  $   434,820.02
After-Tax Balance  $  382,641.62  $   434,820.02
Tax Savings during contribution phase  $    36,300.00  $                  –
After-Tax Balance Plus Tax Savings  $  418,941.62  $   434,820.02
Roth IRA Advantage $15,878.40

 

 (Table 4) Tax Rate Decreases from 22% to 12% and tax savings is invested in a separate account
Traditional IRA Roth IRA
Annual Investment  $      5,500.00  $       5,500.00
Number of years 30 30
Investment Growth Rate 6.00% 6.00%
Working Life Tax Rate 22.00% 22.00%
Retired Life Tax Rate 12.00% 12.00%
Final Pre-Tax Balance  $  434,820.02  $   434,820.02
After-Tax Balance  $  382,641.62  $   434,820.02
Tax Savings during contribution phase plus growth $95,660.41  $                  –
After-Tax Balance + Tax Savings + Growth of Tax Savings  $  478,302.03  $   434,820.02
Traditional IRA Advantage  $                      43,482.01

 

Scenarios described are hypothetical and are provided to illustrate the potential benefits of IRA and Roth IRAs. It is not intended to reflect the actual performance of any security, account, or portfolio. Investments involve risk and you may incur a profit or a loss. Any opinions are those of Mark Meredith and not necessarily those of RJFS or Raymond James. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Raymond James Financial Services, Inc. does not provide advice on tax, legal or mortgage issues. These matters should be discussed with the appropriate professional. Like Traditional IRAs, contribution limits apply to Roth IRAs. In addition, with a Roth IRA, your allowable contribution may be reduced or eliminated if your annual income exceeds certain limits. Contributions to a Roth IRA are never tax deductible, but if certain conditions are met, distributions will be completely income tax free. Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion.