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Roth IRA vs. Traditional IRA: Unraveling the Tax-Free Hype
When it comes to retirement planning, Roth IRAs have garnered significant attention for their enticing promise of tax-free withdrawals in the future. While the allure of "tax-free" is undeniable, it's essential to understand that a traditional IRA can sometimes be a more financially advantageous option. In this blog post, we'll delve into the decision-making process between Roth and traditional IRAs and explore scenarios where the latter may put more money in your pocket.
Imagine you have $5,000 to invest annually in an IRA and earn a 6 percent interest rate. Should you put the money into a Roth or a traditional IRA? The answer depends on various factors, including your tax rate and the time of cashing out. Let's analyze these factors to make an informed decision and maximize your retirement savings.
Roth IRAs tend to get a lot of hype, and for good reason: because you pay the taxes up front, your eventual withdrawals (assuming you meet the age and holding-period requirements—more on these below) are completely tax-free.
While we like “tax-free” as much as the next person, there are times when a traditional IRA will put more money in your pocket than a Roth would.
Making the Decision on What’s Best
Example. Say that your tax rate is 32 percent and that you will invest $5,000 a year in an IRA and earn 6 percent interest. Should you put the $5,000 a year into a Roth or a traditional IRA?
Say further that neither you nor your spouse is covered by a workplace retirement plan, so you can contribute the $5,000 a year without worry because it’s under the contribution limits. If your income is too high for the Roth IRA, you make the $5,000 contribution via the backdoor.
If you invest the $5,000 in a traditional IRA, you create a side fund of $1,600 ($5,000 x 32 percent). On the side fund, you pay taxes each year at 32 percent, making your side fund grow at 4.08 percent (68 percent of 6 percent).
Roth contributions are not deductible; this means no side fund, so your annual investment remains at $5,000.
For the Roth, your marginal tax rate at the time of your payout doesn’t matter because you paid your taxes before the money went into the account. The whole amount is now yours, with no additional taxes due.
But for the traditional IRA, your current tax bracket matters a great deal. You have taken care of the taxes on the side fund annually along the way, but the traditional IRA (both growth and contributions) is taxed at your current marginal tax rate at the time you cash out.
The table below shows you how this looks with tax rates of 22 percent, 32 percent, and 37 percent at the time you cash out (winners are in bold):
You can see that the traditional IRA needs a low tax rate at the time of cash-out to win. But even in the 22 percent cash-out tax rate, the Roth wins at the 40-year mark.
Rate of Growth
What about your rate of growth? Do variances here change things any? Let’s take a look.
Here, we’ll look at different rates of growth for a fixed period (30 years) before you withdraw your money. Once again, we’ll consider three different marginal tax rates at the time you cash out—22 percent, 32 percent, and 37 percent.
n the scenarios above, the traditional IRA/side fund combo wins only when your marginal tax rate is lower at the time of withdrawal and only at the lower growth rates.
At higher rates of return—9 percent and 12 percent, in our examples above—the Roth still wins, even if you’re in a higher tax bracket when you withdraw your money.
What’s going on here? For starters, the side fund is not tax-favored in any way. Plus, taxes hobble your cash-out on the traditional IRA:
You pay taxes as you earn the money in the side fund.
You pay taxes on the accumulated growth inside the traditional IRA when you withdraw the money.