Roth vs. Traditional IRAs: The Tax Trade-Off Isn't Always What You Think

What You Need to Know

Advisors contemplating Roth vs. traditional IRAs rightly focus on the likelihood of future tax increases, but this is not the only dynamic to consider.
A new paper shows that the account type that leads to more wealth also brings more uncertainty — and which account type is which depends on the client.
Ultimately, retirement savers must balance the pursuit of greater after-tax wealth and their desire for more predictable, if more modest, outcomes.

Financial advisors who work with clients focused on saving for retirement are well aware of the uses of both traditional individual retirement accounts, which see taxes assessed upon distribution, and Roth IRAs, which are used for dollars that have already been taxed for income purposes.

In practice, individuals are often advised to contribute to a Roth account if their tax rate is expected to increase in the future, because such an account will have higher after-tax accumulation than a traditional account contribution. The opposite is advised when the tax rate is expected to decrease.

However, according to a detailed new analysis published in the Journal of Financial Planning, “Roth Versus Traditional Account Contributions and Tax Rate Uncertainty,” advisors do not always appreciate the complexity of the Roth versus traditional account decision.

According to the paper, written by David Hulse, professor emeritus in the Von Allmen School of Accountancy and the Martin School of Public Policy and Administration at the University of Kentucky, in any given planning scenario, the type of account with the higher expected after-tax accumulation generally also has higher uncertainty with respect to the targeted outcome.

In other words, there is generally a trade-off to be made between pursuing higher overall retirement wealth and having a higher degree of conviction that one is going to achieve their desired outcome.

According to Hulse, if an individual chooses the account type with the higher expected accumulation, they generally must accept higher uncertainty. On the other hand, if that individual chooses the account type with lower uncertainty, they generally must accept a lower expected accumulation amount.

The importance of these two considerations varies among clients, Hulse says, and a financial planner can use the new paper’s results to help them decide how to best manage such trade-offs.

Setting Up the Analysis

As Hulse spells out, the after-tax accumulation of a Roth or traditional contribution is uncertain because future investment returns are uncertain. The future tax rate is also uncertain, which affects a traditional account’s accumulation.

“One thus might think that a contribution’s after-tax accumulation is more uncertain for a traditional account than for a Roth account, a purported advantage of a Roth account,” Hulse writes.

However, Hulse says his results show that the after-tax accumulation, or ATA, can actually be lower or higher for a Roth account. It all depends on the assumptions one makes about investment returns and tax rate changes.

Hulse says the analysis also shows that this uncertainty is generally higher for the type of account with the higher expected after-tax accumulation. Which type of account this will be depends, in turn, on whether the tax rate is expected to increase or decrease.

Ultimately, for financial planning professionals, these dynamics mean there is a trade-off between a higher expected ATA and lower ATA uncertainty. As Hulse explains, choosing the account type to meet one of these considerations generally means the other consideration will not be met.

Running the Analysis

After spelling out this framework, Hulse’s paper models ATA uncertainty using a sophisticated regression analysis. As noted, the results show that the actual uncertainty can be lower or higher for a Roth account than for a traditional account. The models also show that there generally is a trade-off between a higher expected ATA (i.e., the mean of its statistical distribution) and lower ATA uncertainty.

A Case Study

Hulse steps through several theoretical case studies to show how these dynamics work in practice. In one case, a theoretical retirement saver has $10,000 of before-tax income to contribute, and her current tax rate is 24%. This person, thus, can contribute either $7,600 to a Roth account or $10,000 to a traditional account.

Because of the government’s budget deficits, the individual and her advisor believe that tax rates are likely to increase in the future, but they are unsure about the extent of the increase. She believes her future tax rate has a 20% chance of being 24% (no increase), a 40% chance of being 28% and a 40% chance of being 32%.

Hulse computes that this individual’s uncertain future tax rate thus has a mean of 28.8% and a variance of approximately 0.09%, with a 2.99% standard deviation.

For the investments in her Roth or traditional account, the investor believes there is a 26% chance that each dollar contributed grows to $1.50, a 48% chance it grows to $2.65 and a 26% chance it grows to $4.66. As Hulse explains, this person thus has nine possible combinations of future tax rates and growth figures.

The analysis shows the ATA’s mean for these outcomes is $21,839 for a Roth account and $20,460 for a traditional account. The mean is higher for a Roth account, consistent with the expected tax rate increase from 24% to 28.8%. Notably, the ATA’s variance for a Roth account is meaningfully higher than the variance for the traditional account, with the standard deviations being $8,812 and $8,307, respectively.

Thus, this person faces a trade-off between a Roth account’s higher expected ATA and a traditional account’s lower ATA uncertainty. In another example covered in the paper, the opposite turns out to be true, which Hulse says shows the importance of more nuanced and individualized retirement planning.

Drawing Conclusions

In conclusion, Hulse says, the new analysis shows that the type of account with the higher expected after-tax accumulation generally also has higher uncertainty for it. This means there generally is a trade-off that clients will have to make between these two considerations.

If an individual chooses the account type with the higher expected accumulation, they generally must accept higher uncertainty, Hulse says. If an individual chooses the account type with lower uncertainty, they generally must accept a lower expected accumulation.