It’s an age-old question when it comes to retirement accounts. Should I use a ROTH or a Traditional IRA? Both are great vehicles to prepare for retirement. However, neither are ALWAYS a perfect fit for everyone. Let me break them down a little further to help you understand the differences and when you might want to choose one over the other.
What is the difference in a ROTH IRA and a Traditional IRA?
First, you need to know what each account does and how it shelters your money. ROTH IRA's are the accounts that you place after-tax dollars in. So for example, if you put $5,000 in a ROTH, you’ll get the earnings from that tax-free later in life. Since the money was initially taxed before being placed in the account, it is set up to shield those gains from taxes. Essentially it’s tax-free money for retirement.
A Traditional IRA works the exact opposite. The money placed within these types of accounts is pre-tax dollars. Therefore, you’re getting a tax break up front. When you file your taxes, you’ll often get a tax deduction because you chose to fund a Traditional IRA. However, once you begin to withdrawal that money in retirement, the earning from it are fair game for being taxed at ordinary income rates.
When you look at these two options for retirement, it may look like you’ll end up with better account values if you choose a ROTH. While that sometimes may be true, remember the word ALWAYS is a big NEVER in the financial world. Always is never always when it comes to money. And here’s why.
What do you need to know?
In order to know which account is most beneficial to your retirement plans, there are a few things you need to calculate and examine.
- How much time do you have to invest?
So if someone has more time to save for their retirement, it’s obviously going to affect the outcome of the calculation.
- What is the expected rate of return?
The higher the rate of return, the more a ROTH IRA could benefit, in some cases. If you’re expecting a lower rate of return, then a Traditional IRA might be the better route for you. Again, these are not absolutes, and all other factors mentioned here need to be taken into account.
- What’s the current tax rate?
If you’re paying a higher tax rate (35-50%) when it comes to federal, state, self-employment, etc. then a Traditional IRA in some instances offers the better return for you. However, if you’re in a lower tax bracket (10-15%) currently, then your retirement choice may favor a ROTH.
- What will your future tax bracket be?
Of course, there is a certain amount of uncertainty in this area. We cannot predict the future tax rates to a percentage, but we can make an educated guess. We know right now the tax brackets are rather low, but again, we cannot foretell with certainty every detail to the future tax brackets. These future rates are primarily driven by your future income generating assets, your future asset mix and how each will pay in retirement. So it’s not safe to assume with certainty what their future tax bracket could be. I have some clients with eight-figure accounts paying in the 10-15% range. Yet other clients with seven-figure accounts paying 25-30% in taxes. I have clients with six-figure accounts paying 30 - 40% in taxes. So this is really an unknown variable you’ll just have to play around with.
Knowing all that, how do I determine which is right for me?
When it comes to deciding which is best for you, there’s a retirement calculator that I recommend to my clients, allowing them to play with the variables. Most find it easy to understand and get a good grasp on the comparisons between Traditional IRAs and ROTH IRAs, as well as the after-tax value. So using this simple calculator, I’m going to run you through a couple of examples.
Let’s say someone is 35 years old and planning to retire in 30 years at age 65. Their adjusted gross income is $150,000, and they place $5,500 into an IRA. We are planning to increase contributions to the maximum allowed over that period. They’re going to plan for a constant 7% ROI. We’re also going to say this person is currently paying a 35% tax rate due to federal and state taxes. Now let’s project that in retirement they’ll end up in a 15% tax bracket. The after-tax calculation according to Bankrate calculator comes in at $582,790 for the ROTH IRA, whereas the Traditional after tax prediction is $626,833. That’s an almost $50k difference. Now the reason for that is, the longer savings time frame, a low expected return rate, a high tax bracket currently, yet a low tax bracket in retirement. So for this person, obviously they would benefit more from a Traditional IRA as opposed to the ROTH.
In this example, let’s keep their age the same, 35, their retirement age goal is still 65. Again they’re maxing out retirement contributions to an IRA ($5,500.00 per year). Keeping the exact same tax rates (currently 35% and future 15%), and only changing the expected ROI. Let’s go with 10% instead of 7%. This scenario drastically reduces the difference between the two accounts. The ROTH is now coming in at $1,030,139 and the Traditional (again after tax) is $1,061,711. So still yet, the Traditional tops the ROTH. However, you notice that the ROI is a major component in determining which account could be a better fit.
In a third example, keep all things constant and again only changing the ROI from 10% to 12%. While the numbers still slightly favor a Traditional, you can see at this point it’s a minuscule amount. The ROTH ends up with $1,528,363 in it, while the traditional is $1,535,822. The two are separated by just under $7500. The primary reason for this is because our taxes in retirement are significantly lower.
Now let’s start all over changing the tax rate in retirement. Let’s up it to 25%. So a 35-year-old, this an AGI 0f $150k, planning to retire at 65 currently in a 35% tax bracket with an expected ROI of 7% gets a little different calculation. The ROTH wins out, topping the Traditional by more than $14,000 after tax. The Traditional would garner you $568,554 while the ROTH gives you $582,790.
Note that the rate of return is going to drastically change these numbers. If you kept all other variables the same and upped your ROI to 12%, you can see in this scenario the ROTH IRA is far superior to the Traditional. Your contributions to the ROTH with the gains would come in at $1,528,363. That’s over $145k more than the Traditional IRA after taxes. That account would only garner you $1,382,985.
One more caveat to all of this. Let’s say the person is starting their retirement late in life and is 55 years old. They’re older so they probably aren’t going to invest as aggressively. Instead, they’re earning a conservative ROI of 7%. They’re in a current tax bracket of 35%. They hope for 25% during retirement. Here the Traditional IRA wins hands down at $101,366. Due to the short amount of time this individual has to save, they would come out better if they stay away from a ROTH, which would only give them $96,093.
I give you all this information to show you that it really just depends on some variables. So no one should ever say that it’s ALWAYS better to use a ROTH IRA. Clearly, that’s not necessarily always the case. The always we can really expect is that always is NEVER always. Both accounts have their place in your retirement plans. Consult with your financial professional to help you determine what works best in your particular case.
If in doubt, use a ROTH! After all, it's TAX-FREE GROWTH!