Roth vs Traditional IRA – Which is better

Roth IRA versus Traditional IRA: Which Is Better for You?

 

I can’t think of a more heated tax debate than this topic has been over the years.

This debate is akin to the feud between the Hatfields and McCoys, the Montague and Capulets, the Union and the South, etc. Accountants tend to be split on the decision and as adamant about their opinion being the right one as two football fans debating between Georgia and Georgia Tech.

Yes, Roth IRAs, as the new kid on the tax block (created in 1997) tend to get a lot of attention. Because you pay the taxes upfront, your eventual withdrawals (assuming you meet the age and holding-period requirements) are completely tax-free at least until Congress changes their mind for middle-class earners just like they did on the taxable of Social Security, EE Bonds used for education, Education tax credits, etc. etc. Always remember that nothing is permanent or guaranteed except for Congress’ insatiable desire to redistribute more and more of the money you earn to others. 

I like “tax-free” as much as the next person, but there are times when a traditional IRA will put more money in your pocket than a Roth would.

So if we do some serious number crunching, what do those numbers tell us? Surprisingly there is a clear-cut point at which you should go one direction or the other.

The problem with most comparisons is they don’t factor in the value of money taxed a lower rate at retirement.
It’s logical to assume your income (and your tax rate) should be less in your retirement years than when you’re working full time, but by how much? And how do we weigh this the decision?

Since we have to assume some factors in this equation, let’s say that your tax rate is 32 percent and that you will invest $5,000 a year in an IRA and earn 6 percent interest. Should you put the $5,000 a year into a Roth or a traditional IRA?

Say further that neither you nor your spouse is covered by a workplace retirement plan, so you can contribute the $5,000 a year without worry because it’s under the contribution limits. If your income is too high for the Roth IRA, you make the $5,000 contribution via the backdoor method (see our separate post on how to do this).

 

Now for face-off Traditional IRA in the Red Corner, Roth IRA in the blue corner.

Traditional IRA strategy:

If you invest the $5,000 in a traditional IRA, you create a side fund of $1,600 ($5,000 x 32 percent). On the side fund, you pay taxes each year at 32 percent, making your side fund grow at 4.08 percent (68 percent of 6 percent).

Roth IRA strategy:

Roth contributions are not deductible; this means no side fund, so your annual investment remains at $5,000.

Cashing Out and Judging the Outcome

For the Roth, your marginal tax rate at the time of your payout doesn’t matter because you paid your taxes before the money went into the account. The whole amount is now yours, with no additional taxes due.

But for the traditional IRA, your current tax bracket matters a great deal. You have taken care of the taxes on the side fund annually along the way, but the traditional IRA (both growth and contributions) is taxed at your current marginal tax rate at the time you cash out.

The table below shows you how this looks with the current tax rates of 22 percent, 32 percent, and 37 percent at the time you cash out (winners are in red):

 

Marginal tax rate at cash-out	10 years @ 6%	20 years @ 6%	30 years @ 6%	40 years @ 6%
22%	Trad: $74,557 Roth: $69,858	Trad: $202,074 Roth: $194,964	Trad: $421,482 Roth: $419,008	Trad: $801,048 Roth: $820,238
32%	Trad: $67,571 Roth: $69,858	Trad: $182,578 Roth: $194,964	Trad: $379,581 Roth: $419,008	Trad: $719,024 Roth: $820,238
37%	Trad: $64,079 Roth: $69,858	Trad: $172,830 Roth: $194,964	Trad: $358,630 Roth: $419,008	Trad: $678,012 Roth: $820,238

 

You can see that the traditional IRA needs a low tax rate at the time of cash-out to win. But even in the 22 percent cash-out tax rate, the Roth wins at the 40-year mark. Thus, the younger you are (65-40=25 years old) at the start of either IRA, the more advantage the Roth has. 

Rate of Growth

What about your rate of growth? Do changes here matter?
Here, we’ll look at different rates of growth for a fixed period (30 years) before you withdraw your money. Once again, we’ll consider the three current different marginal tax rates at the time you cash out—22 percent, 32 percent, and 37 percent.

 

Marginal tax rate at cash-out	3% for 30 years	6% for 30 years	9% for 30 years	12% for 30 years
22%	Trad: $257,760 Roth: $245,013	Trad: $421,482 Roth: $419,008	Trad: $716,547 Roth: $742,876	Trad: $1,256,032 Roth: $1,351,463
32%	Trad: $233,259 Roth: $245,013	Trad: $379,581 Roth: $419,008	Trad: $642,260 Roth: $742,876	Trad: $1,120,886 Roth: $1,351,463
37%	Trad: $221,008 Roth: $245,013	Trad: $358,630 Roth: $419,008	Trad: $605,116 Roth: $742,876	Trad: $1,053,312 Roth: $1,351,463

 

In the table above, the traditional IRA/side fund combo wins only when your marginal tax rate is lower at the time of withdrawal and only at the lower growth rates.

At higher rates of return—9 percent and 12 percent, in our examples above—the Roth still wins, even if you’re in a higher tax bracket when you withdraw your money.

Why does it work this way?

The truth is that there are a lot of reasons. For starters, the side fund is not tax-favored in any way. Plus, taxes lessen your cash-out on the traditional IRA in the following ways:

• You pay taxes as you earn the money in the side fund.
• You pay taxes on the accumulated growth inside the traditional IRA when you withdraw the money.

So what’s the take-away?

In the interest of full disclosure, I’m a bit biased against the Roth. Knowing this, I gave it some very pronounced advantages in the above tables. First of all, I’m assuming that a married couple has over $90,000 or so of retirement income before making an IRA withdraw (this is what puts them in the 22% marginal rate). This won’t be true for everyone and, to that extent, the Traditional IRA may win most of the time.
Secondly, the Roth wins at a higher earnings rate of 9% to 12% per annum. Again, not everyone is going to average this level of return. The lower (and perhaps more realistic) rates of 6% will tend to favor the Traditional IRA.
Finally, there is Congress. The Traditional IRA and 401(k) plans are as close to a sacred cow as we get in the tax code. By that, I mean that Congress will offend too many voters with a major change. When Washington is desperate enough (i.e. the Social Security budget becomes tight), we’re likely to see what they’ve done in the past.

Remember we were told for years that Social Security would never be taxable, but it is now if you make much above poverty levels of income. Same thing with interest on EE bonds used for education. I could go on and on, but you get the point.

It’s probably likely that if you have other investment income in your retirement holdings, that someday some of your Roth distribution will be taxable.

Confusing – yes, indeed. But remember.

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