Balancing the Benefits
A closer look at what's good about the Roth IRA
Over the long term, the Roth IRA can overcome benefits that seem
to favor the traditional IRA.
Some people feel you're likely to be better off with a traditional IRA if
you're in a lower tax bracket in retirement than in the year you contribute
to the IRA. That's a possibility, but it won't necessarily work out that
way, especially if you maximize the benefit you can get from the Roth.
How Tax Brackets Affect the Comparison
Let's look at a comparison that seems fair to many people.
Suppose you're willing to put $4,000 into a traditional IRA.
You're in the 25% tax bracket, and that means you'll save $1,000
on your taxes, and the after-tax cost of making the contribution
is only $3,000. If you contribute to a Roth IRA, you don't get a
deduction, so the fair comparison would be with a situation
where you contribute only $3,000, the amount that gives you the
same after-tax cost.
Flash forward 25 years, when we'll assume both accounts would
have grown to 10 times the original value, so you have $40,000
in the hypothetical traditional account and $30,000 in the Roth.
You're retired now, and you can take the money out of the Roth
without paying any tax, giving you $30,000 of spending power.
What about the traditional IRA? You have $40,000 in that
account, but you'll have to pay tax on your withdrawals. If your
tax rate is still 25%, the tax on $40,000 will be $10,000, and
you'll have $30,000 of spending power, the same as you would
have with the Roth IRA. If your tax rate has gone down to 15%,
you'll pay only $6,000 when you withdraw the $40,000, and you'll
end up with $34,000 of spending power. That's $4,000 more than
if you used the Roth IRA.
|This is why many people say the traditional IRA is
preferable to the Roth if you expect your tax bracket to be much
lower during retirement than during the years you make your
There's More to the Story
The benefit of being in a lower tax bracket during retirement
is sometimes called rate shifting. A traditional IRA can
harness that benefit, but a Roth cannot. Yet the Roth can still
come out ahead, even if you expect to see lower tax rates during
retirement. That's especially true if you're able to fund a Roth
IRA to the maximum amount and retain it for a long period of
In the example above, the amount you put into the Roth IRA
was $3,000, the after-tax equivalent (in the 25% tax bracket) of
the $4,000 you put in the traditional IRA. To say it another
way, the example assumed you would put $1,000 more into the
traditional IRA because of the $1,000 of tax savings from
deducting your contribution. There are two problems with this
assumption. One is a problem in theory and the other is a
problem in practice.
The problem in theory stems from the fact that you're allowed
to contribute the same amount in a Roth IRA as a traditional
IRA. Suppose your limit is $4,000 and you would be willing to
save that much in a Roth IRA. To save the equivalent amount in a
traditional IRA you would have to contribute $5,333, but you
aren't allowed to contribute that much. The best you can
do is contribute $4,000 to the traditional IRA and put the
$1,000 from your tax savings into a taxable investment account.
If you do the math, you'll find that you can still come out
ahead with this combination of a traditional IRA and taxable
account if the difference in tax brackets is large enough and
your time frame isn't too long. If we carry the projections far
enough into the future, eventually the Roth will win out, That's
because the combination of traditional IRA and taxable account
requires you to pay current taxes (not deferred taxes) on part
of the investment earnings from your retirement savings. These
projections are always based on guesses about investment
earnings and tax rates far in the future, so you have to take
them with a grain of salt. You can't necessarily rely on an
online "Roth IRA calculator" that tells exactly when the balance
tips in favor of a Roth IRA. The basic principle is sound,
though, and that's why I think people who can make the maximum
contribution should generally favor the Roth even if they expect
to be in a lower tax bracket during retirement.
The Problem in Practice
The problem in practice is one that's often ignored by the
people who design Roth IRA calculators and other fancy ways to
decide which IRA is best. They're assuming the tax benefit from
contributing to a traditional IRA ends up as part of your
retirement savings. They figure that if you're willing to put
$3,000 in a Roth IRA you must be willing to put $4,000 into a
traditional IRA at the same after-tax cost. Likewise, if you're
willing to contribute the maximum amount to a Roth IRA you must
be willing to contribute the maximum amount to a traditional IRA
and add your tax benefit to the long-term savings you
maintain in a taxable account.
This assumption is entirely logical and, for most people,
entirely wrong. It makes sense that people would act this way,
but in reality they do not. People who use traditional IRAs for
their retirement savings do not necessarily preserve the tax
benefits of deducting those contributions as part of their
retirement savings. Instead, they may simply end up with a
fatter checking account than they would have if they saved in a
Roth. That allows them to loosen up on budgeting, which is nice
in a way, but the end result is less wealth in retirement.
The Roth IRA provides other benefits that can offset the rate
shifting advantage of a traditional IRA. The one with the
biggest potential is that the minimum distribution requirement
of traditional IRAs does not apply to Roth IRAs. This only works
for people who have enough other resources during retirement to
avoid tapping their IRAs. If you're in that category, the Roth
will allow you to maintain the tax benefit of your IRA as long
as you want. For people who live well beyond age 70½, the Roth
IRA can make a huge difference in the amount of tax-favored
wealth you have available in your later years, or the amount you
leave to your beneficiaries at death.
The Roth can also provide a benefit on the flip side of the
coin. If it develops that you need money from your IRA before
age 59½, a traditional IRA forces you to run the gauntlet of
available exceptions to the 10% early distribution penalty. If
you can't fit within one of the exceptions, you're stuck with
that added burden. Yet the Roth allows you to withdraw your
regular contributions free of tax or penalty at any time. This
is something you should avoid doing if possible because you're
cutting into the wealth you'll have available during retirement
— but if you need the cash, you'll be glad you could get your
hands on it without paying that 10% penalty.
Then there's the possible tax savings when you draw social
security. Up to 85% of your retirement benefit under social
security can be subject to income tax, but the portion that's
taxable may be lower if your other income is lower. Withdrawals
from a traditional IRA produce taxable income that can boost the
amount of tax you pay on your social security benefit, but
withdrawals from a Roth IRA don't have this effect, as explained
in the next article.