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:
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:
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:
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.)