More On Tax Planningfrom The Advisor's Professional Library
- Cafeteria Plans The income tax treatment of cafeteria plans is key to their popularity. Learn how to maximize the tax benefits of these “flexible benefit plans”.
- Long Term Care Insurance: Premiums While premiums for qualified long-term-care insurance may be deductible as medical expenses there are exceptions to this general rule. Learn how to avoid unnecessary tax liabilities.
Popular with millennials, Roth IRAs have become the token choice for the under-34 crowd’s retirement income. But recent data shows baby boomers might be missing out by sticking with traditional IRAs.
Investors under 34 years old have more than eight times more money in Roth IRAs than traditional IRAs, according to a recent T. Rowe Price study. Investors between 18 and 24 have more than 16 times more money in Roth IRAs. A greater preference for traditional IRAs emerged when the study looked at investors over age 50.
“The benefits of tomorrow’s tax-free retirement withdrawals with a Roth IRA far outweigh the benefits of today’s tax-deduction and other possible benefits with a Traditional IRA,” said T. Rowe Price senior financial planner Stuart Ritter. “Even though the Roth IRA contribution doesn’t qualify for an income tax deduction, decades of compounding tax-free money can generate more spendable income in retirement.”
The study showed that young investors weren’t the only ones able to benefit.
“It’s great that so many young investors are selecting the Roth IRA,” Ritter said. “While the benefits of Roth IRAs are more pronounced for millennials, our research shows the majority of investors would still be better off using a Roth IRA than a traditional IRA.”
The Roth IRA produced more spendable retirement income in most of the scenarios analyzed. Based on data as of year-end 2013, the study examined how much more spendable income in retirement an investor who used a Roth IRA would have compared with an investor who used a traditional IRA.
Based on the study, a $1,000 Roth IRA contribution by a 25-year-old would yield 18% more retirement income than the same amount saved in a traditional IRA if the investors stayed in the same tax bracket.
(The calculations assumed the investor retired at 65, started in the 25% tax bracket and invested the $250 tax deduction from the traditional IRA contribution in a separate, taxable account. They assumed a 7% return for the retirement accounts).
The reason millennials benefit so much from Roth IRAs is because the longer their contributions have to compound tax-free, the more those contributions could be worth in retirement. The study also noted that “younger investors may be in a lower tax bracket today than they will be later when they potentially earn higher salaries. This means that the income taxes they pay on their Roth IRA contributions are taxed at a lower rate today than any potential contributions later.”
The study does also note that there are situations when traditional IRAs are a better option than Roth IRAs.
The traditional IRA looks more valuable in scenarios where the investor is more than 50 years old and his tax bracket drops by at least 9%, as the study showed. While most investors remain in the same tax bracket during retirement, a 65-year-old would only need a 6% drop in her tax bracket for the traditional IRA to be more beneficial than the Roth IRA in retirement.
“A significant drop in tax rates between when the investor made her IRA contribution and began retirement withdrawals can often be offset by the power of tax-free compounding,” Ritter said. “But for investors nearing retirement, there isn’t enough time for the money to compound at a rate to counter the significant reduction in their tax bracket during retirement.”
Andrew Rice, CFO of Money Management Services Inc., suggested in a ThinkAdvisor blog that the Roth IRA may not be as advantageous as it appears.
“Many of you will argue that the Roth IRA is tax-free for life, while the other is taxable when withdrawn. That’s true, based on the current tax laws,” Rice wrote. “However, in my experience many clients live on less money in retirement, usually dropping them at least one tax bracket below where they saved/contributed the money while working.”
Rice added that saving pre-tax instead of after-tax dollars allows clients to build the same sized nest egg while leaving them some extra cash to "live a little along the way" to retirement.
--- Related on ThinkAdvisor: