My March 28 blog— Traditional IRA vs. Roth IRA: What’s Best?— compared the benefits, particularly on taxes, of a traditional IRA to a Roth IRA. Judged by its heavy traffic on ThinkAdvisor, this subject is of great interest in the advisor community, so we’ll continue the discussion and address some reader questions.
A Brief Recap
After reading the comments from readers, I thought a brief recap and additional information might be beneficial.
My conclusion in the original blog was this:
A shorter contribution period favors the traditional IRA. Higher future tax rates favor the Roth IRA. Since the tax benefits of the traditional IRA are realized during the contribution period and the Roth’s tax benefit is realized during the withdrawal period, relative tax rates for both periods are a critical element in this decision.Here is a list of key assumptions I modified to analyze this decision.
And here’s more about my assumptions:
- Amount of annual contributions
- Amount of annual withdrawals
- Number of years for contributions
- Number of years for withdrawals
- Federal and state income tax rates during the contribution period
- Federal and state income tax rates during the withdrawal period
- Average annual return
The contribution assumption posed the greatest challenge.
For example, I ignored the annual IRA contribution limit and assumed $10,000 per year with one caveat. What caveat? If I assumed a $10,000 annual contribution to each, there would be an unfair advantage to the Roth.
Why? In order to invest $10,000 in a Roth IRA, one would need to earn $16,367 (in a 38.9% combined tax bracket) or $13,889 (in a 29.5% combined tax bracket), to have $10,000 after taxes to invest.
If we contribute the same amount in each, we would need to invest the tax savings generated from the deductible contributions in the traditional IRA in a separate account. Therefore, I decided to contribute the full $10,000 to the traditional IRA and $6,110 in the Roth (using a 38.9% combined tax bracket). Although this favors the traditional IRA during the contribution period, the Roth IRA is favored during the withdrawal phase. How?
To receive a net withdrawal of $10,000 from a traditional IRA, one would need to withdraw $16,367 (in a 38.9% combined tax bracket) or $13,889 (in a 29.5% combined tax bracket). In short, the benefit of the traditional IRA occurs during the contribution period while the Roth IRA provides the greatest tax benefit during the withdrawal period.
Next week, we will list seven primary factors and a few general guidelines to help with this all-important decision. We will also address more comments from readers. If you choose to comment and include your name, we will list your name, comment and the response.
Until then, thanks for reading and have a great week!
View all Mike Patton’s blogs on this topic.