Roth vs. Traditional IRA: Which One?

Jan. 1, 2018, will mark the 20th birthday of the first Roth IRA. The after-tax version of the original IRA was likely developed to help present-day politicians collect more taxes while they were in office while pushing the costs of lost tax revenues decades into the future, for others to deal with. Traditional IRAs offer tax deductions on the money contributed. That saves money for people upfront to the extent of their marginal tax bracket. Deferring taxation on future gains until the money is eventually withdrawn sounds good, too. Here is what 30 years of maximum traditional IRA contributions, now $5,500, would grow to if the average annual return were 10%. Picture the result as where it would leave a 25-year-old at 55, or a 35-year-old at 65. After just three decades of contributions, totaling $165,000 of your own money, your account would be worth almost $1.1 million. There's nothing shabby about that. Most of us will have work careers spanning much longer than that, making potential retirement nest eggs even greater. That is not all spendable, though, as the entire amount would become taxable upon withdrawal. It's not possible to know what our future tax rates will be, or the rate of future inflation. Thus, we can't predict the exact amount of after-tax buying power we'd have. Financial planners often fail to make apples-to-apples comparisons when contrasting traditional and Roth IRA wealth building. Because of the traditional IRA's tax savings you would need a much higher amount of money to fund a Roth IRA with $5,500 per year. Someone in the true middle class would avoid about a 25% tax bite on their yearly traditional IRA contributions. That means funding a Roth would take about $7,333 in pretax earnings to make that same $5,500 contribution. Comparing results from $7,333 a year against $5,500 is not valid. Here is the true level-playing-field number based on what would be left to invest when foregoing the upfront tax deduction: 75% of $5,500 equals $4,125. By definition, the total final nest-egg would be exactly 25% lower than if the full amount had been available to invest and compound over time. Of course, the Roth money is tax-paid and 100% spendable. Knowing which IRA type will definitely be best for you is impossible. It's the same thing with paying now for long-term health care insurance or collision insurance for your car. You might be throwing big money away, if you never end up make a claim, or, somewhat ironically, you benefit greatly if tragedy strikes. Because Roths didn't exist until 20 years ago, investments held in Roth IRAs totaled only about 8% of the $7.9 trillion that was held in IRAs overall at the end of 2016. Registered investment advisors note that 85% of traditional IRAs were funded through rollovers, mainly from company 401ks at retirement. Just 12% of newly set-up traditional IRAs were from contributions only. The reverse was true with Roth accounts. Some 71% of newly created Roth IRAs were funded with annual contributions, while 15% came via rollovers from pretax employer plans. About 9% were started as Roth conversions from traditional IRAs. The vast majority of new money is voting for Roth IRAs over traditional ones. That could be a judgment that pre-paying taxes will provide a savings over future tax rates, which figure to be higher. Those who choose Roth accounts are a more affluent group. This can be clearly seen when analyzing the data on IRA withdrawals. Much smaller percentages of Roth account owners took early distributions (prior to age 59) which were subject to penalty, or even withdrawals from ages 60 through 69. In fact, only 5.7% of all Roth IRA owners deemed it necessary to remove cash from their accounts even after age 70. By that time most traditional IRA holders were forced to take money out, and pay taxes on the income due to RMDs (required minimum distributions), whether they needed extra cash or not. If you can afford to forego the upfront tax deduction it seems like the Roth IRA is the better choice. After the first year, the pain of taxes will be out of the way... but the joy of tax-free compounding lives forever. Younger people are typically lower earners. That suggests that the 25% tax savings shown in my example might be well above what they'd actually save in the present by choosing a traditional IRA. The bigger choice, though, is the one which commits to putting aside your own money for retirement rather than counting on government programs to sustain you later in life. The way things are going in America, it's better to treat Social Security as a nice bonus if you eventually see it later, rather than as the financial foundation for your golden years.

Roth vs. Traditional IRA: Which One?

Financial planners often fail to make apples-to-apples comparisons when contrasting traditional and Roth IRA wealth building.

Columnist Conversation

Updated charts JPM C and XLF

Picked Up Netflix Earlier Today

Indicator Update

COLUMNIST TWEETS

Please Join or Log In to manage and receive alerts.