This question has been bothering me for a long time, and now I’m setting out to find the answer to the battle of the Roth and Traditional IRA. The problem being, there are many uncertainties to answering a question like this. A Roth IRA (the word Roth comes from the senator’s last name that introduced the legislation) or Roth Investment Retirement Account is an account in which you invest money that you’ve already paid taxes on, while a Traditional IRA invests your money pre-tax. So, what I’m trying to find out comes down to figuring out if I’ll end up with more money investing pre-tax dollars with a Traditional IRA after paying taxes on those investments in retirement, or would I be better off paying the taxes now and investing those dollars which I won’t have to pay taxes on down the road. I will outline an example to illustrate my conclusions.
The obvious benefit to investing pre-tax dollars is that you have more dollars working for you. For example, let’s say I make $50,000 per year. If I were to contribute pre-tax dollars to an IRA at the maximum level per year, which is currently $5,000, my taxable income would be $45,000. With a Roth IRA, I would be taxed on my $50,000 earned and then invest the after tax dollar max of $5,000. Let’s say my tax rate is 15% in both situations. If I were to have invested pre-tax dollars, I would end up with $38,250 ($45,000 times 1-.15) at the end of the year. With a Roth, investing after tax dollars I would end up with $37,500 at the end of the year after investing the $5000. The difference is $750 more in my pocket at the end of the year with a Traditional IRA.
Now on to my example in trying to figure out which is better. We’re going to have to make some assumptions to make this work. For this example, I’m going to assume I will earn 10% per year, compounded annually on my investments, whether they be in an Roth IRA or traditional IRA. Also, let’s assume I’m 30 years old and will wait to start taking distributions until I’m 65, so my investments will grow for 35 years. For simplicity, let’s ignore the 5-year-rule. Let’s also make the assumption that I’m going to max out my contributions in both scenarios and the limit will always be $5,000. Last, let’s assume I take the difference in what I’m saving by investing pre-tax, and investing that money in stocks earning the same 10% compounded annually.
With a Traditional or a Roth IRA, my investment would grow to $1,631,146.21. But with a traditional IRA, I would have another $750 to invest each year because I had lower taxes due to investing pre-tax. I would earn $244,671.93 additional dollars.
So the question then becomes, because the Roth IRA Dollars are tax-free, will the $244,671.93 additional dollars cover the difference in taxes or not? The fact is, you don’t pay capital gains tax on a traditional IRA, you’re only taxed as ordinary income. On the investments in the stock market, you’re taxed on the capital gains (currently 15% – usually lower than most people’s ordinary tax rate). So Let’s crunch the numbers, we would be left with $207,971 or we would have paid $36,701 in taxes on the capital gains. So, does the $207,971 make up for the difference in taxes we’ll have to pay on the traditional? If we assume a 15% tax rate again (the ordinary tax rate) on $1,631,146.21, we would end up with $1,386,474, or we would have paid $244, 672 in taxes. So, if we take the $1,386,474 and add it to the $207,971, we would have $1,594,445 at the end of the day, or $36,701 less by investing pre-tax dollars.
The winner is clearly the Roth IRA.
What kind of return on your stock investments would be required to beat the Roth? The above assumed that we would only earn 10% on our stock investments, so what rate of return would we have to earn to break even with the Roth? Only slightly over 10%. Earning 11% would actually put me over the top and potentially make a traditional IRA the way to go.
In summary, this is a very simplistic view that is not taking into account future tax rates, etc. By investing in a Roth you eliminate some future potential risks and bite the tax bullet now, however, by giving up taking some risk – you lose the potential for larger rewards by investing in the markets on your own.