The typical advice you’ll hear when comparing traditional and Roth IRAs is to base it on your anticipated post-retirement income. I’ve always personally been in favor of traditional IRAs since I want the tax break now in order to invest more money. Turns out I was right to feel that way… Sort of…
Let’s review what IRAs are and the differences between traditional and Roth IRAs. If you’re already familiar with the differences go ahead and skip this section. A more in-depth review of IRAs can be found here: What’s an IRA?
IRA stands for Individual Retirement Account. These are special investing accounts that allow you to save money for retirement. The accounts come with tax advantages to help funds grow over time. The main way this is done is through tax-free growth. Normally, any gains made from investments are counted as income and taxed as such. In IRAs, these gains aren’t taxed at all. But given the special tax standing for IRAs, there are limits on how much money you can put in them. As of 2018, you can only put in $5,500 per year ($6,500 if you’re 50 or older).
There are two main types of IRAs, traditional and Roth. Both offer tax-free growth but there are some key differences.
Funds put into traditional IRAs can’t be withdrawn without penalty until age 59½. If you do try to take them out before then, you’ll pay a 10% penalty. On the other hand, funds in Roth IRAs can be taken out without penalty. Profits from investments are still subject to the 10% penalty if taken out early, but you can take out up to the amount contributed at any time.
Roth IRAs have income limits that change how much you can contribute. If you make more than $135,000 as a single filer or $199,000 as a married filer, you’re not eligible to contribute to a Roth IRA at all.
On the other hand, traditional IRAs don’t change how much you can contribute based on income. They instead limit the tax deduction you receive based on your income and employment situation. You see, traditional IRA contributions are made on a pre-tax basis. These contributions can be used to reduce your tax bill for the year. Although you can always contribute up to the limit regardless of income, your income and whether your employer offers retirement benefits will affect how much of a tax deduction you receive from your contributions. In exchange for this tax deduction on contributions, distributions (withdrawals) from traditional IRAs are taxed as regular income.
Roth IRAs are reversed. With Roth IRA accounts, contributions are made on an after-tax basis so there’s no tax advantage there. But since the contributions were already taxed when they were put in the account, distributions are not taxed.
The difference between contributions and distributions is where the typical traditional vs. Roth IRA advice comes from. Traditional accounts allow you to pay taxes in retirement while Roth IRAs allow you to pay taxes now. If you expect to be in a higher tax bracket in retirement, then you should go with a Roth IRA. The reasoning is, if you know you would pay more taxes in the future, why not pay the taxes up front at a lower cost?
This type of advice has always bothered me though. Even if I’m going to pay more in taxes in retirement, I don’t expect my tax bill to change that much. Given this, wouldn’t it be better to take the tax break now and invest the extra money? Given a sufficient number of years, investing the upfront tax break should more than make up for any increase in income taxes during retirement, right?
Crunching the Numbers
Everyone’s situation is going to be a little different but seeing how certain scenarios play out can help you make an informed decision about your own situation. For our case, we’ll play out some situations with our friend Tommy. We’ll see if it is indeed better to pay taxes upfront with a Roth in order to pay less taxes in the future, or if it’s better to take the upfront savings with a traditional IRA and invest it. We’ll perform all our calculations in today’s dollars and ignore inflation since both types of accounts are subject to it so it won’t affect our outcome.
She is 25, married, and starting her career with a salary of $60,000. Tommy’s friend at work recommended she invest all her funds in a Roth IRA. Based on this recommendation, she maxes out her contributions and puts them all in a Roth IRA account.
Tommy’s a rock star at work so each year she gets a 2% real raise after inflation. What started out as a $60,000 salary becomes $122,000 at the age of 62. All this time, she’s continued to put funds into her Roth IRA.
Her investments averaged 6% annually, adjusted for inflation, and at retirement, she has $1.34 million. Not bad.
But Tommy doesn’t need anything extravagant in retirement. She mostly wants to maintain the same lifestyle and is expecting to need about 75% of her pre-retirement income, which comes out to be just under $92,000 annually. She’s not planning on working for money and isn’t going to get any other outside income. If her investments continue to perform the way they have in the past, she’ll have enough funds to last her until she’s 90 years old.
Let’s take the same scenario above but instead of taking advice from her friend, Tommy reads up on IRAs. She decides to follow the typical advice and fund a Roth IRA when expecting to pay more taxes in the future.
Tommy is able to forecast her $92,000 requirements and figures out that she’ll be in a lower tax bracket until she’s 38. From age 25 to 38, she funds her Roth IRA since she would have to pay more taxes in retirement. After that point, she funds her traditional IRA until retirement.
With this strategy, at retirement she has $1.4 million. That’s a full $60,000 more! On top of that, with both Roth and traditional accounts, Tommy is able to first pull from her Roth IRA account tax free and continue to defer her tax expenses from her traditional IRA. Doing so helps stretch her funds 2 more years until the age of 92.
So a combined strategy is better than a Roth IRA alone, but what about only funding a traditional IRA?
This time around, Tommy feels it’s better to take the tax break now, invest it, and pay the taxes later. With all the assumptions mentioned above, her nest egg at retirement is just under $1.5 million. That’s expected since she saved all that money from her tax breaks. Tommy now has to pay taxes on all her distributions. With this, her funds last until she’s 93.
As I mentioned in the beginning, I was right! Investing those tax breaks early on paid off for Tommy. It also helps that taxes on long term investments, even in non-tax-advantaged accounts, are very generous. Profits are essentially tax free for the first $38,600 for single individuals or $77,201 for married individuals. After that, profits are taxed at 15%. Much lower than normal income tax. All these factors help make the traditional IRA a better option for Tommy.
But there’s still more to the story.
Let’s imagine that Tommy averages 7% on her investments instead of 6%. With all three strategies, Tommy has more in the bank at retirement, as expected. But as time goes on, something odd happens. The traditional IRA strategy starts to take a nose dive!
What’s going on here?! If we take a closer look, we can see something odd happens around age 78. Well you remember those differences between Roth and traditional IRAs we talked about above? One difference you’ll notice in the table above mentions “Required Minimum Distributions”, or RMDs, for traditional IRAs. These are exactly what they sound like. Once you reach age 70½, the IRS requires that you take out a minimum amount each year according to their formula. The formula is specifically designed to slowly deplete your account until the end of your life.
When Tommy’s investments only made 6%, she didn’t take notice of the RMDs since she was taking out enough to satisfy the IRS’s requirements anyway. But when she has a 7% return, her portfolios start growing faster than she needs to take the funds out.
With either the combined or Roth only strategy, Tommy is able to pull out only what she needs and continue to let her accounts grow. When her funds are in the traditional IRA, the IRS forces Tommy to take out more funds. For example, when Tommy is 75, her expenses are only $92,000 but the RMD for her traditional account is $102,000! When most of her funds are in the traditional account, her RMDs eventually become greater than her actual expenses causing the account value to go down. This gap continues to widen as she gets older.
There are worse things than being forced to spend money. But if you wanted to leave behind an inheritance, you might want to account for that when choosing between IRAs.
The Account That’s Right For You
In the end, determining which account to fund depends on what you want out of retirement. If your goal is to have as much as possible in retirement, then funding a traditional IRA probably makes the most sense. Investing the upfront tax breaks does in fact give you more money. But if you want to leave something behind, you’ll want to consider a combined strategy so you can leave funds in a Roth IRA intact after you pass.