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.
Although the traditional IRA has the tax advantage during the contribution phase, when withdrawals begin, the Roth IRA has the advantage, since qualified withdrawals from a Roth are tax free. This seemed to be the fairest way to compare the two. See table below for more.
The results of the analysis are contained in the graph below.
At the end of the contribution period (25 years), the value of the traditional IRA is 38.9% greater than the value of the Roth. At the end of year 50, even though annual withdrawals from the traditional IRA were increased to $13,889 to net $10,000 after tax, its value is still 41.4% greater than the Roth IRA.