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Roth IRA > Decision Factors
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 contributions.

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 time.
    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.

There's More

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 70, 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 59, 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.


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