Does a Roth IRA offer any explicit benefits over a Traditional IRA?

Question

Using round numbers, let's assume I have $5,000 (pre-tax) to invest annually in an account that earns 10% per year.

In a Roth IRA scenario, this $5,000 would be reduced to $3,750 if we assume a (nice and round) 25% tax rate. For the Traditional IRA, the full $5,000 would be invested.

Now, if we fast forward 40 years, the Roth IRA account will hold roughly $1.6M whereas the traditional IRA will hold closer to $2.2M. This makes sense, as the Traditional IRA account had a larger basis on which to grow annually. However, if we assume that the $2.2M is taxed as the same 25% rate that the Roth money was taxed going in, then we end up with the same $1.6M that is present in the Roth account.

That being the case, is the sole advantage of the Roth account that you 'lock in' your tax rate? In other words, is a Roth IRA play simply a hedge against higher income taxes in the future? Or is there something I'm missing in my analysis?

Answer 1

Your math is correct. As you point out, because of the commutative property of multiplication, Roth and traditional IRAs offer the same terminal wealth if your tax rate is the same when you pull it out as when you put it in. Roth does lock in your tax rate as of today as you point out, which is why it frequently does not maximize wealth (most of us have a higher tax bracket when we are saving than when we are withdrawing from savings).

There are a few other potential considerations/advantages of a Roth:

1. Roth and traditional IRAs have the same maximum contribution amount. This means the effective amount you can contribute to a Roth is higher ($5,500 after tax instead of before). If this constraint is binding for you and you don't expect your tax rate to change, Roth is better.

2. Roth IRAs allow you to withdraw your contributed money (not the gains) at any time without any tax or penalty whatsoever. This can be an advantage to some who would like to use it for something like a down payment instead of keeping it all the way to retirement. In this sense the Roth is more flexible.

3. As your income becomes high, the deductibility of traditional IRA contributions goes to zero if you have a 401(k) at work (you can still contribute but can't deduct contributions). At high incomes you also may be disallowed from contributing to a Roth, but because of the backdoor Roth loophole you can make Roth contributions at any income level and preserve the full Roth tax advantage.

Which type of account is better for any given person is a complex problem with several unknowns (like future tax rates). However, because tax rates are generally higher when earning money, for most people who can contribute to them, traditional IRAs maximize your tax savings and therefore wealth.

Edit: Note that traditional IRA contributions also reduce your AGI, which is used to compute eligibility for other tax advantages, like the child care tax credit and earned income credit. AGI is also often used for state income tax calculation. In retirement, traditional IRA distributions may or may not be state taxable, depending on your state and circumstances.

Answer 2

Couple points:

1) Since the Roth is after tax, you can effectively contribute more than you could with the Traditional IRA before hitting the limits. So in your example, if you had extra money you wanted to invest in an IRA, you could invest up to $1,750 more into the Roth but only $500 more into the Traditional (current limits are $5,500 per year for single filers under 50). Your example assumes that you have exactly $3,750 in spare money looking for an IRA home.

2) The contributions (but not earnings) can be withdrawn from the Roth at any time, penalty and tax free.

3) The tax rate "lock-in" can be significant, especially early on when you are at a relatively low tax bracket, say 15%, but expect to be higher at retirement.

4) Traditional IRAs and 401(k) are taxed as ordinary income, so you go through the tax brackets. Even if the marginal rate is 25%, the effective rate may be lower. If you have a Roth, conceivably you could reduce the amount you need to withdrawal from the Trad IRA/401(k) to reduce the effective tax rate on those (of course subject to minimum distributions and all that). This is more an argument to have a mix of pre- and post-tax retirement accounts than strictly a pro-Roth reason.

Answer 3

This analysis misses the opportunities the Roth IRA presents to those with special access. It assumes that all money grows at the same rate, with investments at regular intervals. These assumptions hold for normal workers, but not for the privileged.

Suppose, for example, that in a single year you have limited access to a security that is an acorn you know will grow into a mighty oak; for this example, this security will grow 1000x over some short period of time. For simplicity, assume both the value of acorns you can buy and the the maximum IRA contribution in this year is $5K.

After the short acorn growth period, the after tax values are:

• IRA $5M * (1 - .25 [income tax, illustrative only]) = $3.75M
• Roth IRA $5M

There is a minor difference in the amount of money you need to buy the acorns (pre v. post tax), but this is negligible relative to the amount of cash you can assume you have on hand to have special access.

The Atlantic provides an acorn example from private equity (not used with a Roth) and this Washington Post article describes someone with non-publicly traded startup stocks and a Roth.

Answer 4

Time to look at a tax table.

A retired couple hits the top of the 15% bracket with an income of $96,700. (I include just the standard deduction and exemptions.) The tax on this gross sum is $10,452.50 for an 'average' rate of 10.8%.

This is what 2 answers here seem to miss, and the 3rd touches, but doesn't keep going.

The tax, paid or avoided, upon deposit, is one's marginal rate. But, at retirement, the withdrawals first go through the zero bracket (i.e. the STD deduction and exemptions), then 10%, then 15%.

The Roth benefit is maximized

• Use the Roth to deposit when in the 10 or 15% bracket
• Use Roth conversions to 'top off' the 15% bracket when able to do so
• Using a more sophisticated method of multiple account/asset conversions and annual recharacterizations to magnify the value of converted funds.

In the end, to choose between Traditional or Roth, one would have to have far more details regarding the person's financial situation. The right choice is rarely 100% known except in hindsight.

Answer 5

In a Roth IRA scenario, this $5,000 would be reduced to $3,750 if we assume a (nice and round) 25% tax rate. For the Traditional IRA, the full $5,000 would be invested.

No, that's not how it works. Taxes aren't removed from your Roth account. You'll have $5,000 invested either way. The difference is that you'll have a tax deduction if you invest in a traditional IRA, but not a Roth. So you'll "save" $1,250 in taxes up front if you invest in a traditional IRA versus a Roth.

The flip side is when you withdraw the money. Since you've already paid tax on the Roth investment, and it grows tax free, you'll pay no tax when you withdraw it. But you'll pay tax on the investment and the gains when you withdraw from a traditional IRA. Using your numbers, you'd pay tax on $2.2MM from the traditional IRA, but NO TAX on $2.2MM from the Roth. At that point, you've saved over $500,000 in taxes.

Now if you invested the tax savings from the traditional IRA and it earned the same amount, then yes, you'd end up in the same place in the end, provided you have the same marginal tax rate. But I suspect that most don't invest that savings, and if you withdraw significant amount, you'll likely move into higher tax brackets.

In your example, suppose you only had $3,750 of "discretionary" income that you could put toward retirement. You could put $5,000 in a traditional IRA (since you'll get a $1,250 tax deduction), or $3,750 in a Roth. Then your math works out the same. If you invest the same amount in either, though, the math on the Roth is a no-brainer.

Answer 6

There's a serious mistake in your analysis: granted, in the traditional IRA, you avoid paying taxes on the $5000 now, but you're now stuck paying taxes on $2.2 million dollars when you withdraw it later. Obviously, you'll end up paying massively more than $1250 in taxes on this in the end.

As other people have pointed out, if you can afford to cut the $1250 elsewhere in your budget, you could still end up with the $2.2M. However, let's say just for argument that you don't; the question then becomes if you're better off taking the tax hit on the $5,000 now or the $2.2 million later.

It also really matters how much money you'll be withdrawing when you retire as well as how you'll be doing the withdraws. Personally, my goal is to be able to withdraw as much per year as my highest salary while working, so clearly the Roth IRA is a good deal for me.

An important consideration here is that most people believe that their expenses will go down when they retire, but the majority of retirees in some surveys have indicated that their expenses either stayed approximately the same or actually increased.

Also, quick reality check: would the fact that you know you'd be saving $1250 on your taxes by contributing to the IRA actually cause you to contribute an extra $1250 to your retirement? Even if you personally would, I highly doubt that most people, with the exception of people who post on this site :), actually think that way (especially given how little most people actually save for retirement).

Answer 7

Fast Forward 40 - 45 years, you're 70.5. You must take out ~5% from your Traditional IRA. If that was a Roth, you take out as much as you need (within reason) when you need it with zero tax consequences. I don't know (and don't care) whether they'll change the Roth tax exclusion in 40 years. It's almost guaranteed that the rate on the Roth will be less than the regular income status of a Traditional IRA. Most likely we'll have a value added tax (sales tax) then. Possibly even a Wealth Tax. The former doesn't care where the money comes from (source neutral) the latter means you loose more (probably) of that 2.2 MM than the 1.7. Finally, if you're planning on 10%/yr over 40 yrs, good luck! But that's crazy wild speculation and you're likely to be disappointed. If you're that good at picking winners, then why stop at 10%? Money makes money. Your rate of return should increase as your net worth increases. So, you should be able to pick better opportunities with 2.2 million than with a paltry 1.65 MM.