Recently I have seen a few erroneous or incomplete comments regarding Roth vs. traditional IRAs. Since:
- The "Roth" 401k authorized in the 2001 tax act has gone into effect beginning in 2006,
- Beginning in 2005 the $100,000 AGI limit on IRA conversions does not include RMDs making them available to more people, and
- Beginning in 2010 the AGI limit on conversions to a Roth is eliminated entirely,
I thought an analysis might have some value.
Many comparisons of vehicles with differing tax treatments are faulty (including recent articles in a national publication and an industry journal) because they don't start at the beginning and go all the way to the end. To perform a proper analysis, it is important to start with "Joe earns a dollar" and go all the way to "Joe spends the proceeds". If the comparison starts with "Joe puts $X in the accounts" or stops with "the account values are $X", the conclusions are frequently inaccurate (and in some cases intentionally so).
Here is a quick mathematical comparison of a Roth vs. a traditional (deductible) IRA.
Let's assume a 25% marginal tax bracket that is the same throughout Joe's life.
- Joe earns $1,000
- He pays $250 in income taxes on it
- He puts the remaining $750 in a Roth
- It doubles while it is in there to $1,500
- He takes it out and gets to spend $1,500
- Joe earns $1,000
- He puts it in a deductible IRA (no taxes because it is tax deductible)
- It also doubles and thus becomes $2,000
- He takes it out and pays 25% ($500) in taxes
- He gets to spend $1,500
As you can see, there is no difference between the two vehicles under those assumptions.
Now it gets more complicated. I assumed above that the tax brackets stayed the same. Here are the confounding factors:
- If the marginal tax bracket is lower in retirement, it will favor a deductible option, if it is higher, it will favor the Roth option.
- I also assumed that Joe did not max out the IRA, if he contributes the max, it will favor the Roth. This is a little complicated but basically because the Roth takes after-tax funds, and the limits are the same, he can in essence get more earnings into a Roth. An example may clarify this:
Same assumptions as above, but assume Joe is going to save pre-tax wages of $4,000 while the maximum contribution level is $3,000.
- Joe earns $4,000
- He pays taxes on it ($1,000 in the 25% bracket)
- He places the remaining $3,000 in a Roth
- It doubles to $6,000
- He withdraws the funds and gets to spend $6,000
Scenario 2 - IRA portion:
- Joe earns $4,000 and puts $3,000 in a deductible IRA, (no taxes on that portion because it is tax deductible)
- The $3,000 in the IRA doubles to $6,000
- He withdraws the funds paying $1,500 in taxes
- He gets to spend $4,500
Scenario 2 - remaining portion:
- Joe pays $250 in taxes on the remaining $1,000 (of the original $4,000)
- He invests the remaining $750 in his taxable account
- It doubles, but has some drag and capital gains taxes due on withdrawal
- At withdrawal, the after-tax amount available to spend is less than $1,387.50
(The $750 in the taxable account will do less than double because of taxes on dividends, interest, and turnover, but even if we assume it did the full double, it would become $1,500 with a basis of $750. Even at a 15% capital gain rate the taxes would be ($1,500 - $750)*.15=$112.50. So even in a perfect world he would have $1,500 - $112.50 or $1,387.50)
Adding the $1,387.50 to the $4,500 proceeds from the IRA and it totals $5,887.50 which is less than the $6,000 from the Roth. In reality the difference would be somewhat greater. (Note: If an investor uses very efficient investments like an index fund or ETF that has little turnover and small distributions, and holds it till death, it receives a step-up in basis to the heirs and the overall effect is similar to a Roth. The higher the turnover and distributions, the more inefficient it becomes.)
- Some people with access to a qualified plan may still be able to do a Roth even though their earnings are too high for a traditional IRA.
- I believe the traditional IRA may be a little better if you are concerned about the children squandering their inheritance. Psychologically, having to pay taxes on discretionary withdrawals may be just the thing to restrain them from taking more than the RMD.
- A major assumption is the tax rate in the future. This depends not only on the client's financial situation, but also on tax policy at that time. There seems (to me) to be a long-term trend toward lower marginal rates on a broader base (which is a good thing!). If this continues, traditional IRAs will be favored. In addition, the deduction for a traditional IRA happens now, while the Roth is merely a future promise. I am skeptical of government promises, though it may seem inconceivable that Roth proceeds will be taxed someday, at one point it was also inconceivable that Social Security benefits might someday be taxed.
- If there is a desire to leave funds to charity upon death, a traditional IRA will give a tax deduction now for that future contribution. In other words, you get a tax deduction for putting funds into the traditional IRA. You can name the charity as beneficiary (or contingent beneficiary) and you got a tax deduction for that gift. Not so with the Roth.
To recap, when both a deductible IRA and Roth IRA are available:
Roths are better for people when:
- Tax rates will increase for them in the future (either because of their personal situation or tax rates in general change)
- They are trying to save more than the limits
- They have estate tax issues (the income taxes paid upfront will no longer be in the estate)
- They do not want to be forced to draw money after age 70 1/2
- They trust the tax break will still exist
- They will not leave the funds to charity
Traditional IRAs are better for people when:
- Tax rates will decrease for them in the future (either because of their personal situation or tax rates in general change)
- They are not trying to save more than the limits
- They don't have estate tax issues
- They will need to withdraw funds to live on in retirement anyway
- They don't trust the government promises
- They will leave the funds to charity
Each individual and their advisor will have to weigh the relative importance of these factors to decide which vehicle is right for them.
Finally, a non-deductible IRA is inferior to both the deductible and the Roth (unless there is intent to convert it to a Roth in the future). It should be compared with a taxable account, where given a very long time horizon or very tax-inefficient investments, the IRA has advantages. However, because of the lack of flexibility (early withdrawal penalties), more difficulty harvesting losses, and loss of the step-up in basis on death, I would generally choose a taxable account over a non-deductible IRA.