How to Choose Between the Traditional IRA and a Roth IRA
Confused by the conflicting opinions about how to decide which of these two personal retirement accounts is the better choice? Most advisors focus on the tax vs.
no tax aspect and the difference between income tax rates when you are younger and when you are older.
The prevailing consensus appears to be that it's better to go with the Roth IRA if you believe that future income tax rates will be higher than they are today.
How do you really decide? Determine the present value of the deferred tax expense inherent to the traditional IRA then you have the answer.
Even the smallest amount of tax that is deferred and paid decades into the future has a significant beneficial effect on the future value of the regular IRA (referred to as IRA).
How do you prove it? Your age is 30 ½.
Your current tax bracket is 25%.
A $6,000 contribution to the regular IRA will save you $1,500 of income tax this year.
Alternatively, the after tax contribution to a Roth IRA is $4,500.
At age 70 ½ required minimum distributions start for the regular IRA.
Keeping the withdrawal rate and tax rate constant at 5% and 25%, respectively and using 7% for the rate of return for the next 25 years the total of the tax payments is $34,408.
When that series of payments is discounted to today, the present value is $1,084.
To make this an "apples - to - apples" comparison, let's split the regular IRA into 2 components: (1) a future income tax reserve component for $1,084; (2) the tax free component of $4,916.
This is greater than the after tax Roth IRA.
Said another way, $1,084 has to be set aside today in order to pay back the $1,500 that was deferred - a net benefit of the traditional IRA of $416.
Project this permanent difference to age 95 and the traditional IRA has a greater value by nearly $34,000 over the Roth.
Your tax rate would have to jump to 32% before there is parity between the two accounts.
If there is a tax year when you have absolutely no tax benefit from the Traditional IRA deposit, then use a Roth.
You can have both accounts.
This may be the situation for younger people who are not yet fully employed and earn part time income with no income tax liability.
One last remark.
The part that makes the traditional IRA a tax preference over Roth is that deferred taxes are paid back over time - money stays invested longer and you reap the benefits of compounding.
no tax aspect and the difference between income tax rates when you are younger and when you are older.
The prevailing consensus appears to be that it's better to go with the Roth IRA if you believe that future income tax rates will be higher than they are today.
How do you really decide? Determine the present value of the deferred tax expense inherent to the traditional IRA then you have the answer.
Even the smallest amount of tax that is deferred and paid decades into the future has a significant beneficial effect on the future value of the regular IRA (referred to as IRA).
How do you prove it? Your age is 30 ½.
Your current tax bracket is 25%.
A $6,000 contribution to the regular IRA will save you $1,500 of income tax this year.
Alternatively, the after tax contribution to a Roth IRA is $4,500.
At age 70 ½ required minimum distributions start for the regular IRA.
Keeping the withdrawal rate and tax rate constant at 5% and 25%, respectively and using 7% for the rate of return for the next 25 years the total of the tax payments is $34,408.
When that series of payments is discounted to today, the present value is $1,084.
To make this an "apples - to - apples" comparison, let's split the regular IRA into 2 components: (1) a future income tax reserve component for $1,084; (2) the tax free component of $4,916.
This is greater than the after tax Roth IRA.
Said another way, $1,084 has to be set aside today in order to pay back the $1,500 that was deferred - a net benefit of the traditional IRA of $416.
Project this permanent difference to age 95 and the traditional IRA has a greater value by nearly $34,000 over the Roth.
Your tax rate would have to jump to 32% before there is parity between the two accounts.
If there is a tax year when you have absolutely no tax benefit from the Traditional IRA deposit, then use a Roth.
You can have both accounts.
This may be the situation for younger people who are not yet fully employed and earn part time income with no income tax liability.
One last remark.
The part that makes the traditional IRA a tax preference over Roth is that deferred taxes are paid back over time - money stays invested longer and you reap the benefits of compounding.