If you are waiting until the last second to fund your 2006 IRA, you’re probably not alone. Maybe you are still confused about choosing between a Roth or a Traditional IRA. Here’s an interesting fact: If you assume that your tax rates will be the same now as they are in retirement, the amount you end up with is the same whether you use a Traditional or Roth IRA. This is independent of time length and expected return

Let’s assume an annual investment rate of return of 8% for the next 30 years, and a marginal tax rate of 25% for all years. Let’s also say that you only have \$1,500 of after-tax (\$2,000 gross pre-tax) income to put away right now.

If you went with the Roth IRA, you pay your 25% tax on the \$2,000 now (\$500), but no taxes upon withdrawal:

\$2000 x 0.75 x 1.0830 = \$15,094

If you went with the Traditional IRA, you don’t have to pay tax on the \$2,000 right now, but you’ll be taxed upon withdrawal:

\$2,000 x 1.0830 x 0.75 = \$15,094

See how they are the same? The only difference is that you are able to put away “more” in a Roth IRA since the limits are \$4,000 for either one. \$4,000 post-tax in a Roth IRA is like putting away \$5,333 in a Traditional IRA in this scenario. This ability to shield more money from taxes is why I chose to contribute to a Roth IRA. Now, if you change your assumptions about tax rates, that’s where you may start leaning more towards one or the other.

How good is the tax benefit?
Remember, either IRA saves you tax at least once. If you just kept it all in a regular taxable account, you would be subject to a tax on any dividends or realized capitals gains every year. Let’s see what happens to your \$1,500 then. Taking the best case scenario of investing in stocks with only dividends being taxed and having no capital gains to deal with until you sell 30 years later, we’ll assume that the 8% annual return is broken down into 6% appreciation and 2% dividends. If the 2% in dividends are taxed at 15% each year, your after-tax return in 1.7%. If those dividends are reinvested:

\$1,500 x (1.077)30 = \$13,885

At the end of 30 years, upon selling you’ll have a long-term capital gain of \$13,885 – \$1500 = \$12,385. You pay tax of 15% on that: \$1,858, leaving you with \$13,885 – \$1858, or \$12,027.

With these simplified assumptions, using an IRA made you over 25% more money than if you didn’t use one. If you invested in any bonds, the difference would be even greater. 25% is huge! Imagine ending up with \$500,000…. or \$625,000. Which one would you rather have? This is why IRAs are a great opportunity to make your money go farther.

(This is not a comprehensive Roth vs. Traditional IRA post – There are just so many variables like the ability to take out principal without penalty, ability to use balances for a 1st home, required minimum distributions, and easy of inheritance to consider.)

1. Miller says:

I’ve done quite a bit of research on this topic. Overall, you hit the nail on the head. The topic gets much more complicated and interesting (because Roth and deductible traditional IRAs are no brainers like you show!) when you consider higher income people who’s only option is *non* deductible traditional IRAs versus “normal” accounts. In that situation, there are a number of instances when the normal account is better because IRA withdrawals will be taxes as income (higher) where as normal accounts will be taxed as capital gains (lower).

Here’s a shameless plug on a piece I wrote about that:

The conclusions basically say put highly taxable investments in a non-deductible traditional IRA (if you can’t use something better) like bonds, high dividend funds, or high turnover funds. Everything else (index funds) are *better* in a normal account…

2. Tindey says:

what you don’t take into account how tax planning affect when and how you save…

example:

when i am putting away \$ into the Traditional IRA when you are a regular workin’ stiff it does not affect my overall income…

unlike a roth ira which will be taxed right away….

this can greatly affect one’s taxes

additionally your pure market comparison is just a little lacking b/c over that long of a time period you would start off with higher yield higher risk stock. Which would help accelerate your nest egg, and as you age you would decrease your level of risk

…that would give you the best return in the open market because only the use of an IRA would impede your ssavings potential

one needs to understand that a personal blend of options is what one needs to adequately save for the future.

but love the article and your site

sorry about the thought only i just thought I would see the direction of conversation to include the importance of a blend of options

3. Wonderer says:

To be explicit, the Roth IRA is the obvious winner IF you are able to contribute at the maximum rate each year.

Another point of comparison besides the expected in-retirement tax rate is the distribution requirement of each type. A Traditional IRA mandates draw-down begin at age 70.5, whereas a Roth can stay put until you die (if you don’t need it).

4. Brian says:

The ROTH is the obvious winner if you plan on being in a higher tax bracket upon retirement. If you are a poor college student who doesn’t pay any taxes, go with the ROTH.

I also like the added flexibility of being able to take out the ROTH principal whenever I want.

5. Mike H says:

This makes it seem like it is going to be a tougher choice when I’m in a 25% or higher bracket. Who knows what taxes are going to be like in 50 years? Before now I thought the Roth was a sure bet for the rest of my life no matter what my bracket was. I don’t really feel like having both kinds of IRAs even if it “diversifies my tax exposure.”

6. ttfitz says:

A note about Roth’s for parents – the dollars that go into a Roth don’t have to be the dollars earned. This means that if your child has any earned income, you can contribute your money, up to the amount of their earned income (or the contribution limits if they earn enough), to a Roth IRA on their behalf.

Makes for a good little nest egg for the kids, while making it harder for them to blow it on a sports car.

7. mimi says:

Just thinking about tax-free investments — if you had say, a painting, which today was worth about \$100, but would be worth around \$15000 in 20 years (some upcoming artist), what tax would you owe when you sold it? You definitely wouldn’t be paying tax on it every year it becomes more valuable, so isn’t that kind of like an IRA? What about buying gold by the brick? Other investments also allow for tax free growth, right? Are there any other ones that don’t involve an actual IRA? Somehow I like the idea of a “secret” investment that grows tax free.

8. Brian says:

Mimi,

Things like gold, silver, even stamp collections that may appreciate in value are considered “collectibles” by the IRS and are taxed at 28% when you sell. For example, I have some of the gold ETF (GLD) and if I were to sell, even after having it for >1 year, it does not qualify for long-term capital gain rates – it will be taxed at 28% (or your marginal rate if less than 28%). So, in your scenario, if you sold all \$15k at once after 20 years, you would owe (15000-100)*.28 = \$4172 in taxes, leaving you with \$10828.

9. TallWes says:

Jonathon,

Regardless of what a person has “available”, if your income tax rates pre and post retirement are equal, the IRA is always the winner from a net worth standpoint.

The primary reason is that one needs to factor in the “income tax reduction” and invest that in a taxable account subject to LG cap gains.

i.e.:
Roth is:
\$2000 x 0.75 x 1.08^30 = \$15,094

IRA is:
\$2,000 x 1.08^30 x 0.75 = \$15,094 (IRA portion invested)
+
(.25 x \$2,000) x 1.08^30 x 0.85 = \$4,277 (Inc Tax portion invested)
For a total of \$19,371

The Inc Tax portion is the \$500 extra you get back from your income taxes, invested in a taxable account, taxed at LTCG when withdrawn.

From a net worth standpoint, IRA’s a winner.

-Wes

10. Andy says:

Mimi: If you buy stocks that don’t distribute dividends this is exactly the same scenario, except that you get (well, at least right now) the 15% tax on capital gains, which is nice.

Of course you can’t really buy stocks that will never distribute dividends. If you buy a total stock market index fund then this is a reasonably good approximation. The current yield is

11. Question: Please don’t laugh too hard at me ok?

Ok here goes.

Re: Trad Ira–Would I pay taxes on my entire gain upon withdrawal or my initial deposit of \$2000

another way of asking my question–

Do I have this correct inmy head? TRAD IRA–I pay \$500 taxes on \$2000 and if my account grows to \$500,00 (dream) I would only pay taxes on my inital deposit and not the \$500,000 gain????

12. TallWes says:

tanyetta:

You would pay Federal & State Income Tax on the entire amount withdrawn at the time of withdrawal.

13. Tanyetta –

Traditional – You don’t pay taxes initially, so instead of having \$1,500 take-home you’d be allowed to put \$2,000 into the Trad IRA. After it grows, whatever you take out of the IRA, it doesn’t matter if it’s a gain or not, it is going to be taxed at your ordinary income tax rates.

In your example, if it grows to \$500,000, you would have to pay income tax on anything you withdrawal out of the \$500,000. But you’d probably take out a little bit at a time.

For a Roth IRA, you DO pay the tax initially. So you only have \$1,500 to put in the Roth (and thus less money to grow). BUT, when you are all done, you don’t have to pay any tax on it upon withdrawal.

Traditional – No tax on the way in, tax on everything on the way out.

Roth – Tax on the way in, but no tax on the way out.

14. Brian says:

The way I look at it is (all else, such as your current/future tax brackets, being equal), the choice is also somewhat dependent on which you think is more likely:

– That the marginal tax brackets will be increased so as to cause you to pay markedly more taxes in the future than you anticipate now (in which case Roth’s advantages are magnified); or

– That, by the time you retire, the law will have changed such that some or all of your Roth distributions will have become taxable (in which case Roth’s advantages are greatly diminished).

I’m a pessimist, and tend to doubt that, forty years from now, Roth withdrawals will be as tax free as they are now–after all, if I recall correctly, the promise at social security’s inception was that those benefits would be fully non-taxable, given that the money had already been taxed as income. Guess how long that lasted.

15. Heather says:

Brian finally I’ve met someone who is as paranoid as I am!!

Jonathan – I’m really weak with math, and I don’t think well when I’m hungry, but could you explain again where the 1.7% and the 1.077% numbers come from in the last example?

16. Miller says:

Wes, I disagree with your counter example, and here’s why. Let’s compared pre-tax dollars to pre-tax dollars (can’t compare apples and oranges, right?).

So, for your Roth example, \$2000 is your pre-tax money. That’s why you take 75% of it foward to your compounding. Okay.

On your IRA example, you use \$2000 again (good), compound it, then pay taxes. But then you add another factor in… what you call the tax return (via the deduction). The problem is you used \$2000 initially *pre-tax*. That means you’re already effectively counting the tax refund. If not, you would have had to multiply the first \$2000 by 75% like you did with the Roth.

So, you are effectively using more pre-tax money in your IRA account than your Roth account, and that’s why it looks better to you.

17. Phoenix says:

Jonathan, all the variables you mentioned in the parentheses at the end of your blog tip the scale towards the Roth. One oft overlooked benefit of a Roth that i learned about in a tax class and as of yet i have NEVER heard mentioned anywhere else, is that with a Roth after a minimum period (i believe it’s 5 years) you can take out regular periodic distributions UNTAXED, as long as the distributions are the same each time and the periodic intervals between distributions remains the same. It could be once a month, every quarter, every other week…as long as the distribution is the same.

This really comes in handy if you have some high yield stocks or even a % of rental property in the Roth trust account, then you effectively shield current income before you’re 50 y/o! Great way to send payments to your kids when they’re in college (after your 529s have paid off tuition and other school expenses).

18. TallWes says:

Miller, you are correct. My excuse is that I was thinking of a debate I had with a friend a few years ago regarding which is better from a net worth standpoint, ROTH or Trad., and I should not have included that tax factor in the above.

Thanks for setting me straight.

-Wes

19. Brian says:

I have a question of the forum. I’ve been maxing out my wife my ROTH IRAs for the past several years. I’m investing up to company match with my 401k. I have some extra money that I would like to set aside in the stock market, but I want to avoid a taxable account. I really don’t want to invest more in the 401k either.

We just had our first child a few months ago. I have thought that a 529 account might be a good home for some of the extra savings. I also contemplated opening up a ROTH IRA for my kid. As I understand the ROTH, education expenses are exempt from the 10% early withdrawal penalty (like the first time home purchase). However, the interest is taxable.

Any thoughts on what investment vehicle to chose for my extra savings?

20. Phoenix says:

Pardon my comment earlier that
“you can take out regular periodic distributions UNTAXED, as long as the distributions are the same each time and the periodic intervals between distributions remains the same.”

These distributions are exempt from the 10% additional tax on early distributions when taken before the age 59-1/2. However, any portion of the distribution that exceeds the basis of the Roth will be taxed as regular income.

21. circlefun says:

This is my formula to compare Roth IRA and Traditional IRA.

I assumed tax rate to be the same, 25%, both now and 30 years later.
Let X be the original amount of money you put into Roth IRA and Traditional IRA
Let R be the rate of return you get from your investment

Roth IRA:
Total return = X (1+R)30

Total return = Return from IRA + Return from saved tax
Return from IRA = X (1+R)30(0.75)
(Since Traditional IRA is taxable when you take money out, you only have 75% after tax)
Return from saved tax = 0.25X (1+ 0.75R)30
(Since we saved 25% tax, our new principle amount is 0.25X. Since this money is not in IRA, it is taxable at 25%. Since the tax applies every year for 30 years, investment return rate is 0.75R instead of R)
Total return = X (1+R)30(0.75) + 0.25X (1+ 0.75R)30

According to those formulas, Roth IRA is a winner. You can plug in number for X and R to test.

22. jpsfranks says:

Brian,

I’ve heard of parents getting creative with the requirement that IRA contributions be from earned income, but I think it would be difficult to explain how a baby a few months old had income to contribute to a Roth.

23. TallWes says:

circlefun : in your Roth calulation you are missing the fact that you pay tax on the money going in, there fore the formulas and results come out identical.

Also, you say “Since this money is not in IRA, it is taxable at 25%. ” That is incorrect, it would ideally be taxed at a long term cap gains rates.

24. circlefun says:

TallWes:
The fact that you need to pay tax going into Roth IRA has already been taken care of in Traditional IRA’s formula. It is the “saved tax investment” portion. You can take care of that tax by either decreasing the amount of investment in Roth IRA’s formula or increasing the amount of investment in Traditional IRA’s formula, you don’t do both. I chose the latter because I want to max out my IRA in either case.

As for tax bracket. I assumed a constant 25% for simplicity reason. You should change it to fit your own situation. For example, you will want to assume 30% tax bracket now and 20% tax bracket 30 years later. For money not in IRA, you can assume 15% tax bracket like you suggested. Then the new formulas will be:

Roth IRA: X (1+r)^30

I plugged in different “r” to try. When r=0.08, that is 8% return for your investment, Traditional IRA performed better. When r=0.1, that 10% return for your investment, both IRA perform the same. When r=0.12, that is 12% return for your investment, Roth IRA perform better.

The result really depends on what tax bracket you have in the future and what rate of return your investment will have. I am the kind of person who never want to retire, so tax bracket will stay the same for me at 30%. Roth IRA is always better for me in that case.

25. circle – To be clear, your calculation only makes sense if you are trying to max out the Roth IRA and you can’t make the equivalent contribution to the Traditional IRA. Otherwise, you are making the Traditional IRA look worse than it necessarily is.

For example, \$4,000 post-tax in a Roth IRA is like putting away \$5,333 in a Traditional IRA in this scenario. But you can’t put \$5,333 in a Traditional IRA, so that is where you might start with your line of calculations. (How to treat the taxable portion depends on what you’re investing in)

However, if you wanted to put in \$2,000 in a Roth vs. \$2,667 (2000/0.75) in a Traditional IRA, then your calculations make the Traditional IRA look worse than it necessarily is.

Roth IRA:
Total return = X (1+R)30

Total return = Return from IRA + Return from saved tax
Return from IRA = X (1+R)30(0.75)
Return from saved tax = 0.25X (1+ 0.75R)30

you would have

Roth IRA:
Total return = X (1+R)^30

Total return = Return from IRA + Return from saved tax
Return from IRA = X / 0.75 * (1+R)^30 * 0.75 = X (1+R)^30

Which makes both equal, bringing me back to the point that the only difference is that you are able to shield “more” money in a tax-advantaged account via a Roth IRA since the limits are \$4,000 for either one. This feature is what makes the Roth more desirable when the tax in and out is assumed equal. Whenever you have to put away any money in a taxable account, however you choose to account for the taxation, the result will be less desirable than in a Roth or tax-deductible Traditional IRA.

26. circlefun says:

Yes, totally agree. My calculation assumes maxing either Roth IRA or Traditional IRA.

27. Well, only if you max out the Roth IRA, as if you max out the Traditional IRA they are still equal.

28. mimi says:

I’m not sure if there are two Brians here or one, but first; Brian and Heather, I have also been very suspicious of the Roth IRA from the first time I heard it would be “tax free” when withdrawing. Somehow I feel like that will all be forgotten by the time we retire. Suddenly, it will be like “sorry guys – we need more money and S.S. is a complete mess”. Anyway, I might get into one just long enough for my daughter’s college education (because you can remove the principal without penalty) and then keep the rest for a rainy day fund which I feel WILL be taxed whether they say so or not.

And, Brian – who is looking to put money into a 529 – I think this is a great idea for your extra money. Because you get to deduct the entire amount from your state taxes for the year. Where I live (New York), my state tax is roughly 6.5%, so this is a considerable savings. I’m also toying with an idea about borrowing, say the entire amount I want to put into my daughters 529 for the year (say \$2000) from my 403b in the beginning of the year (a one year loan). The cool thing is that the loan has a pretty low rate (around 6% too), and since I get the tax deduction, it’s basically free (plus I’m putting the money back into my account anyway). And the best part is that her college fund grows from the beginning of the year with the borrowed money.

29. TallWes says:

CircleofFun:
a) I don’t think you’re fully understanding Jonathon’s posts. If you don’t believe it, compare your results to this:
http://www.banksite.com/calc/rothira (use \$0 for the current balance)

b) You said:
“Return from saved tax = 0.25X (1+ 0.75R)30
(Since we saved 25% tax, our new principle amount is 0.25X. Since this money is not in IRA, it is taxable at 25%. Since the tax applies every year for 30 years, investment return rate is 0.75R instead of R”

Money that is NOT in an IRA is not in an IRA, it’s in taxable account. Taxable at Short/Long Term Capital Gains Rates, not at income tax rates.

30. TallWes says:

mimi, et al:

Roth account contributions made now will be tax free. The congress can not/would not go back and place a “retroactive” tax on Roth withdrawals. Think about it.

Also, it’s very different than placing an income tax on SSI income.

-Wes

31. Heather says:

Wes –

I’ll steal an argument from Lawrence Starr; we know for sure that (deductible) IRA contributions are tax free today, but we don’t know that Roth contributions will be tax free in the future. So you are giving up a certain benefit for an uncertain benefit.

But of course my motto is: perfect paranoia is perfect awareness. 🙂

32. jpsfranks says:

I agree with TallWes. It seems very unlikely to me that any money already contributed to a Roth will be rendered in any way taxable due to future legislation. The worst I can imagine is that the rules could be amended for future Roth contributions, although even that I think unlikely.

While I am about as cynical as anyone when it comes to Congress, to change the Roth rules they would pretty much have to explicitly break the promise of the Roth, and for probably relatively little additional tax revenue.

On the other hand adjusting the marginal income tax rates up is very easy to do, breaks no promises (except the read my lips variety), and raises a ton of money since it affects all income, not just retirement account withdrawals. In my mind this only strengthens the argument in favor of a Roth over tax-deferred accounts.

33. TallWes says:

Heather :
Just to be clear, I didn’t say anything about “future ROTH contributions”.

Could congress in the future come up with some formula to tax the INCOME/GAINS from TODAY’s contributions? Possible, but unlikely.

Could congress decide in 2021 to eliminate future ROTHs, very possible, but my current ROTH account would most likely still exist.

After all, ROTH’s are just a federal accounting gimmick to increase today’s tax revenue. If congress eliminated ROTH’s the net effect is that it would decrease current tax revenues – unlikely they’ll do that!

-Wes

34. TallWes says:

As an add on to my prior comment, I decided to do a google and see if the mainstream though that Roth was a gimmick, low and behold:

http://www.cbpp.org/3-28-06bud-background.htm

35. mimi says:

No, they’ll let you pay the taxes up-front, defer for 30 years while the account is building, and charge you at the end. Thus turning the Roth into nothing more than a mutual fund (that was never cashed out) — except you could only withdraw from it for special purposes. Okay, maybe this won’t happen — but consider the group of people they are trying to get with the Roth. Not rich people (there are income limits), not poor people either (who don’t have anything to sock away, much less \$4000). The people who will utilize the Roth seem to be people in the middle class teetering towards the upper middle class – the government’s favorite target for robbing ;>

But, hey, if you have the extra money, at the very least, it’s just savings anyway.

36. Heather says:

Wes is correct, I misspoke and I should have phrased it as Mimi did. Also I really agree with her follow up comments: that it is best suited for low income folks, but is marketed to others.

The Roth IRA article Wes cites is pretty interesting, if I understand it correctly the phase-out of Roth income limits in 2010 for the purpose of temporarily increasing tax roles, to offset the lower dividends tax rate. Sounds plausable.

I ran through the Excel spreadsheets kindly provided by Miller at http://www.MyPocketChange.com and for my purposes (tax bracket and desire to invest non-IRA monies in stocks) the taxable account appears to beat the IRA (I’m phased out of Roth.)

37. Spencer says:

Jonathan, I haven’t noticed errors in your posts before but I have to point out that in this post your math was confusing. Technically, the real reason you end up with the same return in your IRA comparison is that the two equations you used are identical. That doesn’t affect the result in this situation, but the lack of parentheses made reading the equations difficult since they aren’t logically related to their respective IRA type.

38. TrailFez says:

Are the “tax brackets” being discussed here a little skewed? Just because you fall into the 25% bracket doesn’t mean that all of your income is taxed at 25%, just the portion of your income that is above the 25% limit. So, assuming that your income level from distributions in retirement will be lower than it is now, your effective tax rate would also be lower in retirement. This would have the affect of making the Traditional IRA more attractive the higher your current income level is, since more of your current earnings are taxed at 25%.