The question of whether to use a Traditional IRA or Roth IRA is sometimes spoken of with a level of mystique behind the forces at work for each option. The fact is, the benefits of each of these plans is quite straightforward. However, the long-term effect of those benefits is where things can get a bit murkier.
First, let’s define a few things so we’re all on the same page.
Traditional IRA: a retirement account where a tax deduction is taken at the time of contribution and taxes are paid when you take withdrawals
Roth IRA: a retirement account where contributions are made with money that’s already been taxed and no tax is paid on withdrawals.
Contribution: The money you deposit into your IRA
Next, let’s take a look at how taxes impact your contribution with each option. We’ll assume you want to contribute the 2017 limit (prior to age 50) of $5,500 and pay a combined state and federal top tax rate of 30%
Traditional IRA
Income Available: $5,500
Taxes Paid: $0
Actual Contribution: $5,500
Roth IRA
Income Available: $5,500
Taxes Paid: $1,650
Actual Contribution: $3,850
So, at first glance, it would appear that the Traditional IRA is the better option as more money makes its way into your retirement account. However, it’s important to remember that the tax will be paid on the Traditional IRA on the tail-end. So, assuming an 8% rate of return for 30 years on this deposit and the same 30% tax in retirement here’s how much you’ll be able to withdraw.
Traditional IRA
Starting value: $5,500
Value in 30 years: $55,344
Taxes Paid on Withdraw: $16,603
Amount Received: $38,741
Roth IRA
Starting value: $3,850
Value in 30 years: $38,741
Taxes Paid on Withdraw: $0
Amount Received: $38,741
As you can see because of what’s known as the Commutative Law of Multiplication it doesn’t matter where the tax occurs, on the deposit or on the withdraw. If the tax rate, the percentage of income paid, is the same it doesn’t matter if you pay it on the front end or the back end. While you paid fewer dollars in absolute tax using the Roth IRA ($1,650 in the Roth vs $16,603 in the Traditional) you also started with less money to compound. Therefore, your ending result is the same.
So, why would someone choose one option over the other?
The question of whether you should go the Traditional IRA or Roth IRA route is not a question of which one is more profitable but a question of your current tax rate versus your potential future tax rate. The problem here is that you’ll never know with certainty your future tax rate at the outset. This is why it’s often a wiser idea to split contributions between both options, giving you maximum flexibility in the future.
However, in some instances, you may reasonably expect your tax situation to be much different in the future than it is today. For instance, if you’re in a fairly high tax bracket now but have a high level of confidence that you’ll be much lower in retirement then allocating that tax to the future may make perfect sense. Or, if you are in a fairly low tax bracket now but expect to inherit or receive significant taxable income in retirement you may want to pay tax on your contributions now and not have them add to your taxable income in the future.
Here are a few reasons why each option may be worth considering.
Why a Traditional IRA?
- You’re in a higher tax bracket now than you expect to be in retirement
- You pay state tax now but want to retire to a low/no income tax state
- Contributions would take you down a tax bracket
Why a Roth IRA?
- Your tax bracket is fairly low and you expect to be in the same bracket or higher in retirement
- You have a pre-tax employer plan and want a mix of tax-free and taxable income in retirement
- You may have state income tax in retirement
Unfortunately, since none of us can say for certain what taxes will look like in 10, 20, or 30 years the Traditional vs Roth IRA question comes down to planning around the uncertainties. By giving yourself options on both sides of the tax equation you allow yourself maximum flexibility through a wide range of tax situations you may face. This is why having and updating a financial plan throughout your investing journey is important. Proper planning allows you and your financial advisor a chance to discuss and plan for different scenarios early enough for them to have their desired impact.