Regarding IRAs vs. Roth IRAs, I once heard a bit of advice from a local financial advisor on the radio, and I recently decided to take a better look at it. The advice essentially goes like this: When choosing between an IRA and a Roth IRA, the investor should not only consider one's probable tax rate at retirement, but one's current tax rate. The advisor went further and suggested that those in higher tax brackets would be better off with a traditional IRA, investing the deferred taxes every year in a taxable investment account. To avoid significant taxes one should invest in a market index, such as the S&P 500 (SPY) or NASDAQ (QQQ). The logic is that the amount deferred on taxes each year, if significant enough, will earn enough money to offset the amount paid in taxes on the IRA upon withdrawal.
I loved the idea of this, probably because it added a new dimension to the Traditional vs. Roth IRA discussion. I like financial advisors who look at an individual's present situation and try to match advice to it, rather than the typical "yahoo advice column" formula solution. I felt this was one step closer to that. The advice is still somewhat simple ... dumbed down, if you will. We, the great masses, are left with the idea that if we are in a high tax bracket, we merely need to enroll with a traditional IRA and invest the tax savings from our contributions every year. If we happen to be in a low tax bracket, a Roth is our ticket to geriatric leisure.
Having a twisted sense of what constitutes entertainment, I decided it would be fun to compare the two options and see how they hold up to scrutiny.
Ok. Great. So how do the numbers add up. Before I present my results, let me explain what assumptions went into the numbers, as they greatly affect the outcome.
Methodology
- Baseline - I chose to assume the full $5000 per year allowed for a married couple. I understand this amount will increase in the future, but for simplicity, I did not assume a growth rate. Furthermore, while single individuals can contribute less, which ends up favoring the Roth, their marginal tax rates are also likely to be higher, favoring traditional IRAs. I felt for simplicity's sake, I should leave contributions at the maximum amount possible.
- Timeline - I needed to choose a length of time to measure the Roth vs. traditional IRA. I chose a starting investment age of 25, and ended the contribution stage at age 60. I started the withdrawal period at 60 and ended it at 85. While some invest at an earlier age, and some will not start withdrawing at 60, I felt given people's propensity to put off saving, this was a good balance. Longer periods of time will favor the traditional IRA option.
- Growth Rate - I assumed a 10% per year growth rate for both Roth IRA savings, and the Traditional IRA savings both inside and outside the tax shelter.
- Methodology - For the baseline (Roth) I started with $5000 in year one and grew it by 10%. Then, I completed each subsequent year by adding $5000 and growing that total by 10%. In year 35 (60 years old), I amortized the total over the 25 year "retirement" period, using a 5% growth rate, to account for reduced risk portfolios. Finally, I divided that amount by 12, and taxed it by the various tax rates I chose as my examples.
For the Traditional IRA, I used the same time period, and the same growth rate, but added an additional amount of money each year to account for the re-invested amount from tax savings. That amount varied for 6 different sample tax rates an individual could be paying at participation time. Of course, after amortizing it, I did not tax it. For those of you still following along, you may notice that this does not account for taxes or brokerage fees levied against the money now in taxable accounts. Since the taxes deducted will be dependent on changing laws, what someone invests in, the investing timeline, etc, I chose avoid simulating it. But it deserves bearing in mind.
Results
Current Tax Rate | ||||||||||
Roth | 10.00% | 15.00% | 25.00% | 28.00% | 33.00% | 35.00% | ||||
Anticipated Tax Rate | ||||||||||
15% tax | $7,921.91 | $7,404.50 | $7,839.32 | $8,410.82 | $8,612.08 | $8,947.52 | $9,081.69 | |||
20% tax | $7,921.91 | $6,968.94 | $7,378.18 | $7,916.06 | $8,105.49 | $8,421.19 | $8,547.47 | |||
25% tax | $7,921.91 | $6,533.39 | $6,917.05 | $7,421.31 | $7,598.90 | $7,894.87 | $8,013.26 | |||
30% tax | $7,921.91 | $6,097.83 | $6,455.91 | $6,926.56 | $7,092.30 | $7,368.54 | $7,479.04 | |||
35% tax | $7,921.91 | $5,662.27 | $5,994.77 | $6,431.80 | $6,585.71 | $6,842.22 | $6,944.82 | |||
40% tax | $7,921.91 | $5,226.71 | $5,533.64 | $5,937.05 | $6,079.12 | $6,315.89 | $6,410.60 | |||
Ok. So the thought behind this advice has some validity. If you are young, but in a very high tax bracket, and you for some reason think your taxes are likely to be very low when you retire, and you are disciplined enough to invest every bit of money you save by contributing to your IRA, you may come ahead with a traditional IRA vs. the Roth.
But is someone who is 25 and already in the 28% tax bracket likely to be in a very low tax bracket upon retirement? Are tax brackets likely to stay this low in the future? Will taxes become more damaging to taxable accounts in the future? All of these questions need to be answered to your satisfaction before choosing the traditional IRA over a Roth.
Furthermore, consider that a Roth IRA allows you to borrow your contributions (only) penalty free, whereas any money placed in a traditional IRA is locked into the shelter until retirement. Any emergency withdrawal will come with taxes and hefty penalties. I like flexibility, and penalties to withdraw my money serve as a strong disincentive.
On the other hand, the Roth IRA option comes with the risk that its tax privileges will be revoked, and those looking forward to seeing their tax free payments in the future will be burned. Since the traditional IRA allows us to avoid taxes now, and each year in the future, we can at least pretend the government won't find a way to take more.
Summary
I still like this line of thinking, but I'm afraid you have to be a special kind of optimist about tax rates in the future for the traditional IRA to make sense. If you are starting much earlier, say in your teens, the numbers may just work out for you. If you feel you have a special situation, and don't want to go to the work of building the spreadsheet, write me and I'll gladly send you my work. You can tweak the numbers to your liking.
Bottom line, for most of us, the Roth IRA makes an awful lot of sense. The numbers work out in most cases without taking into account taxes on investments outside the IRA, tax rates are probably the lowest that most of us will ever see in our lifetimes, and the Roth is one of the few hedges against rising taxes that most ordinary investors have. Finally, the government holds a big card in their hand, limiting the value of the traditional IRA. Tax regulations built to limit tax deductibility by those in the higher tax brackets. I have a strong feeling that as tax rates rise, we will not see those limits rise nearly as fast. If so, there will be few people in the future who should elect to open a traditional IRA.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
