UPDATED 1-FEB-2013: There was an error in our original post that only affected the Roth IRA calculations. This article has been re-written to account for the error.
This is a frequent question. The usual answer is "it depends on future income tax rates", which is true. But that doesn't really answer the question. How much do income tax rates need to change in order to make a significant difference? Do investment returns affect the decision? This article is going to give some specific examples to show how a Roth and traditional IRA compare with changing income tax rates and investment returns. We will also show how "equal" contributions are not actually equal.
All calculations for this article used our IRA calculator spreadsheet, available on the calculators page of our web site.
Since the goal of this article is to understand which type of IRA is "better", we will define "better". For the purposes of this article, we define "better" to mean:
Prior to showing how income tax rates affect the Roth versus traditional IRA comparison, we need to make a point regarding contributions. We see a common error in many comparisons of Roth versus traditional IRAs regarding contributions. The error is that the comparisons start by assuming you make contribution of equal amounts to each type of plan. The problem is that a contribution to a Roth IRA costs you more than a contribution to a traditional IRA, because the Roth contribution is after income tax.
In this example, a person has $100K in gross income, pays 25% average income tax, and a marginal rate 5% higher (or 30%). Then $6K are contributed to either a traditional IRA, or a Roth IRA; the traditional IRA contribution is before taxes and the Roth IRA contribution is after taxes.
Because the traditional IRA contribution reduces gross income, less income taxes are paid. In this example, a Roth contribution of $6K is equivalent* to the combination of a $6K traditional IRA contribution AND a $1800 contribution to a taxable account. Alternatively, you could have contributed $8570 to the traditional IRA, had no taxable account contribution, and still had a net income of $69K. (As of the time of this writing, the maximum contribution is $5500, and an additional $1000 catch-up for qualified individuals. To contribute $8570 to a tax deferred plan would require a 401K plan. The purpose of this example was just to show the difference of pre and post tax contributions, independent of contribution limits.)
* By "equivalent" we mean that both examples result in the same net income after contributions to savings; but the contribution amounts are not the same due to tax treatment.
All calculations for this article assume Roth contributions are reduced by taxes. Said another way, both the Roth and traditional IRA have the same pre-tax contribution amount.
What if you make the maximum contribution regardless of plan type?
You should consider challenging our fundamental assumption regarding equal contributions. That assumption is correct for someone who is planning on contributing the traditional IRA equivalent of a maximum contribution OR LESS. But a maximum Roth contribution, as just pointed out, is more after-tax dollars than you can contribute to a traditional IRA. If you are going to make the maximum Roth contribution, and contribution limits stay the same for both types of plans, the Roth will have an advantage over the traditional IRA. Why? No capital gains are paid on Roth returns, but the traditional IRA alternative is a maximum contribution plus an additional amount in a taxable account. The capital gains in the taxable account reduce the total return relative to the Roth IRA.
The remainder of this article will give examples to show how income taxes affect the IRA types. From one example to the next, we will only change one assumption. All charts will be kept to the same scale. Common to every scenario:
Now let's look at an actual example of how the balances of a Roth and traditional IRA increase, then decrease, over time. With no change in tax rates, the traditional IRA produces a slightly longer retirement. This is because all Roth contributions were taxed at the higher marginal rate. If the marginal rate is zero, the retirement duration is exactly equal. Also note that the traditional IRA appears to have a much higher balance, but that is only because the account balance is the gross balance (income taxes not paid). Thus for a given income, you have to withdraw more money from the traditional IRA each year, and the traditional IRA balance depletes faster.
Increasing taxesNow let's assume that taxes immediately start increasing by 0.5%/year, to a maximum of 40%. Now the Roth has an advantage over the traditional IRA. The reason is that all of the traditional IRA income is now taxed at the maximum rate of 40%, while the Roth paid lower taxes as contributions accumulated.
We show this example not because we think income taxes will decrease, but to be consistent and show the counter example to the above. This time we modeled income taxes as immediately starting to decrease 0.5%/year, to a minimum of 10%.
Remember this is a blog post designed to investigate how income tax changes and investment returns affected the Roth versus traditional IRA decision. There are other considerations, and you should always consult with your financial and tax advisors before making any decisions. But there is one aspect of the Roth IRA we want to make sure everyone is aware of.
Thus one way to use a Roth IRA would be as a secondary "savings" account that, should emergency needs arise, you could take withdraws from without penalty. (Again, the penalty is only on early withdraws on investment returns, which are removed after contributions.)
ConclusionMany Roth versus traditional IRA comparisons mistakenly compare equal contributions to both account types. This error greatly exaggerates the benefits of a Roth IRA. It is possible to create scenarios that lead to either plan type appearing favorable over the other. It is up to the reader to predict the future, and decide which IRA type is "better" for them.
Thanks for reading!
Paul F. Dunn - Owner
Simple Allocation LLC - Simple investment allocation for the experienced investor