Which is the best choice for clients when it comes to retirement savings: a traditional IRA or a Roth IRA? This question has been pondered countless times since the Roth was introduced in the Taxpayer Relief Act of 1997. Proponents argue that a Roth IRA is better for individuals with a longer time horizon, because interest comprises a larger portion of an account’s total value as the years progress. In addition, qualified withdrawals from a Roth IRA are tax-free.
Therefore, since interest is a larger component of an account’s value over longer periods, the tax savings for younger individuals is greater with the Roth. This is precisely what I used to think, that is, until I ran the numbers. Let’s take a look.
Here are the assumptions used in this analysis.
1) Contributions: $10,000 (beginning of year)
2) Contribution period: Years 1-25
3) Withdrawals (after tax): $10,000
4) Withdrawal period: Years 26-50
5) Average annual return: 8.0%
6) Federal income tax rate during contribution/withdrawal period: 35%/25%
7) State income tax rate during contribution/withdrawal period: 6%/4%
8) Combined tax rate during contribution/withdrawal period: 38.9%/28% (state income tax is deductible on federal tax return)
Note: The rules and/or penalties pertaining to contribution limits, early withdrawals (pre age 59½), and mandatory withdrawals (RMD at age 70½), have been ignored. The table below contains additional details on the contribution and withdrawal methodology.
Assume each individual begins with $10,000 in earned income. Contributions to a traditional IRA are pre-tax, whereas the Roth IRA investor must pay taxes prior to investing. If we contributed the same amount to each, the Roth IRA investor would have to earn $16,367 to have $10,000 to invest after paying taxes.