Roth Vs Traditional IRA

 

Dear Client:

Roth IRA versus traditional IRA: which is better for you?

Roth IRAs tend to get a lot of hype, and for good reason: Because you pay the taxes upfront, your eventual withdrawals (assuming you meet the age and holding-period requirements—more on these below) are completely tax-free.

While we like “tax-free” as much as the next person, there are more times than you would imagine when a traditional IRA will put more money in your pocket than a Roth would.

Making the Decision on What’s Best

Example. Say that your tax rate is 32 percent and that you will invest $5,000 a year in an IRA and earn 6 percent interest. Should you put the $5,000 a year into a Roth or a traditional IRA?

Say further that neither you nor your spouse is covered by a workplace retirement plan, so you can contribute the $5,000 a year without worry because it’s under the contribution limits.

Traditional IRA

If you invest the $5,000 in a traditional IRA, you create a side fund of $1,600 ($5,000 x 32 percent).

On the side fund, you pay taxes each year at 32 percent, making your side fund grow at 4.08 percent (68 percent of 6 percent).

Roth IRA

Roth contributions are not deductible; this means no side fund, so your annual investment remains at $5,000.

Cashing Out

For the Roth, your marginal tax rate at the time of your payout doesn’t matter because you paid your taxes before the money went into the account. The whole amount is now yours, with no additional taxes due.

But for the traditional IRA, your current tax bracket matters a great deal. You have taken care of the taxes on the side fund annually along the way, but the traditional IRA (both growth and contributions) is taxed at your current marginal tax rate at the time you cash out.

The table below shows you how this looks with tax rates of 22 percent, 32 percent, and 37 percent at the time you cash out (winners are in bold):

 

Marginal tax rate at cash-out 10 years @ 6% 20 years @ 6% 30 years @ 6% 40 years @ 6%
22% Trad: $74,557

Roth: $69,858

Trad: $202,074

Roth: $194,964

Trad: $421,482

Roth: $419,008

Trad: $801,048

Roth: $820,238

32% Trad: $67,571

Roth: $69,858

Trad: $182,578

Roth: $194,964

Trad: $379,581

Roth: $419,008

Trad: $719,024

Roth: $820,238

37% Trad: $64,079

Roth: $69,858

Trad: $172,830

Roth: $194,964

Trad: $358,630

Roth: $419,008

Trad: $678,012

Roth: $820,238

You can see that the traditional IRA needs a low tax rate at the time of cash-out to win. But even in the 22 percent cash-out tax rate, the Roth wins at the 40-year mark.

Rate of Growth

What about your rate of growth? Do variances here change things any? Let’s take a look.

Here, we’ll look at different rates of growth for a fixed period (30 years) before you withdraw your money. Once again, we’ll consider three different marginal tax rates at the time you cash out—22 percent, 32 percent, and 37 percent.

 

Marginal tax rate at cash-out 3% for 30 years 6% for 30 years 9% for 30 years 12% for 30 years
22% Trad: $257,760

Roth: $245,013

Trad: $421,482

Roth: $419,008

Trad: $716,547

Roth: $742,876

Trad: $1,256,032

Roth: $1,351,463

32% Trad: $233,259

Roth: $245,013

Trad: $379,581

Roth: $419,008

Trad: $642,260

Roth: $742,876

Trad: $1,120,886

Roth: $1,351,463

37% Trad: $221,008

Roth: $245,013

Trad: $358,630

Roth: $419,008

Trad: $605,116

Roth: $742,876

Trad: $1,053,312

Roth: $1,351,463

In the scenarios above, the traditional IRA/side fund combo wins only when your marginal tax rate is lower at the time of withdrawal and only at the lower growth rates.

At higher rates of return—9 percent and 12 percent, in our examples above—the Roth still wins, even if you’re in a higher tax bracket when you withdraw your money.

Tax Factor

What’s going on here?

For starters, the side fund is not tax-favored in any way.

Plus, taxes hobble your cash-out on the traditional IRA:

You pay taxes as you earn the money in the side fund.

You pay taxes on the accumulated growth inside the traditional IRA when you withdraw the money.

If you would like to discuss how the Roth or traditional IRA can fit into your retirement plans, please call me on my direct line at 972-780-0303.

 

Have a bless and prosperous day,

Burleigh C Foreman