A Tale of Two IRA Contributors
If you are one of the lucky Americans who find they suddenly have individual retirement account options--that is, you’re eligible to contribute to both a tax-deductible IRA and a Roth IRA--you have a tough choice to make.
The maximum you can contribute to all IRAs in a single year is $2,000 per person. So unless you want to split your contribution--and double the annual IRA fees you pay--you’ll have to decide whether the Roth or the traditional, tax-deductible IRA is better for you.
How do you do that? There are rules of thumb, such as: You’re better off with the traditional IRA if your tax bracket is likely to fall at retirement, but you’re better off with the Roth if you may need access to some of your money before age 59 1/2. However, to figure out the best economic answer, you have to run the numbers. Reality is much more complicated, of course, but here are some simplified guidelines to help you estimate.
How? Let’s consider two hypothetical taxpayers, John Smith, age 35, and Jane Jones, 55. For example’s sake, we’ll say both are in the 28% federal income tax bracket while working. However, at retirement--thanks to a company pension and hefty savings--Smith jumps into the 31% bracket. Jones, on the other hand, has a smaller pension and less savings. At retirement, she drops into the 15% tax bracket.
Smith contributes $2,000 per year to a Roth. He invests the money in stocks and earns an average annual return of 10% during his working career. He retires 30 years later and finds that his Roth IRA is worth about $376,748.He can take that money out in a lump sum, he can withdraw it over time, or he can let it sit. He’s not required to take distributions from a Roth if he doesn’t want to. (With a traditional IRA, you must start taking distributions when you reach age 70 1/2.) None of that money is taxable, so Smith gets to keep the full $376,748.
What if he’d put his money in a traditional deductible IRA instead? This analysis is more complex because he gets $560 in upfront tax breaks each year. (A $2,000 tax deduction is worth $560 per year to someone in the 28% bracket.)
That’s money he wouldn’t have had if he’d invested in the Roth, so to make an apples-to-apples comparison, we have to assume that he invests that $560 outside of his IRA at the same time as he invests his $2,000 contributions inside his IRA.
At the end of 30 years, his traditional IRA--worth $376,748--is fully taxable at his 31% ordinary income tax rate. He pays $116,792 in federal income tax, leaving him with $259,956.
However, he also has a taxable account that he funded with the $560 in annual tax breaks. Assuming he earned a 10% average return, this account is worth $105,490 at retirement. The investment earnings on this account--everything except his principal of $16,800--is taxed at capital gains rates. He pays $27,494 in tax on this account, leaving him with $77,996.
In the end, he nets $337,952 ($259,956 plus $77,996) from the traditional IRA--about $38,800 less than with the Roth.
Meanwhile, Jones contributes $2,000 a year for five years to a Roth. But since she’s a conservative investor fairly close to retirement, she invests her money in a mixture of stocks and bonds and earns an average annual return of 7%. Five years later, when she wants to start taking her money out, she has $11,932. None of that money is taxable.
Had she chosen to contribute to a traditional IRA instead, Jones would have had to pay tax on the entire amount at her ordinary income tax rate. However, because her tax rate (and income) dropped at retirement, she pays just 15%. Her tax obligation on the traditional IRA amounts to $1,790, leaving her with $10,142.
Meanwhile, she would have collected $2,800 in tax breaks over the five-year contribution period.
If she also invested that money earning an average of 7% annually, this account would be worth $3,341. She’ll pay tax on the investment earnings--$3,341 minus her principal of $2,800.
Since some of the accumulation is capital gains and some is probably interest and dividends, let’s assume her “blended” tax rate is 13%. (For taxpayers in the 15% bracket, capital gains rates drop to 10%.) She pays about $70 in federal income tax on that account.
In the end, choosing a traditional IRA over a Roth would leave her ahead by $1,481.
What would have happened if they’d both remained in the same tax bracket when they retired?
Then the Roth IRA would have been a bit better than a traditional IRA for both Smith and Jones, but the margin would be narrower. Smith would have about $17,700 more with the Roth; Jones would net $124 more with the Roth.
