When I was fresh out of college and starting my first job, my dad convinced me that I needed to start saving for retirement. Even if it was just a little bit, getting started early was important. Thanks dad!
At the time I was working for a small start-up without an employer-provided retirement plan, so I needed to figure things out on my own and quickly found my way to the IRA. What an ingenious little device! A retirement account you can set up on your own and invest pretty much however you want? Pretty cool!
So I went about setting one up and quickly found that I needed to make a choice. Did I want to open a Traditional IRA or a Roth IRA? I went out in search of advice and found the response to be pretty much unanimous: a Roth IRA was the way to go. The logic was the same no matter where I looked and went like this:
- I was young and in a low tax bracket.
- Someday I would be older and in a higher tax bracket.
- Given that, I should pay the taxes now to get tax-free income later.
Makes sense right? It did to me. So I opened up a Roth IRA and happily stuffed it with money for years without so much as a second thought.
But over the years I continued to learn, and in that time I’ve discovered that the logic that leads people like myself to a Roth IRA is flawed. In fact, the Traditional vs. Roth IRA debate looks a lot different when you actually run some numbers and see the results.
So today I want to show you the truth behind the Traditional vs. Roth IRA debate in the hopes that you can make a more informed decision than I did when I started out.
Why the conventional wisdom is harmful
Let me get this out of the way. As long as you’re saving for retirement you’re doing a great job. As I said in my series on how to start investing from scratch, the most important decision you can make is to get started, not which IRA you choose. That has not changed.
With that said, the end goal of investing is to have saved as much money as you need within the timeframe you need it. If there are easy ways to make that more likely, you should take advantage of them.
The problem with the conventional wisdom in the Traditional vs. Roth IRA debate is that it’s mathematically incorrect, and it therefore leads a lot of people down an inefficient path. It’s not a bad path, it’s just that for many people there is a better one that will help them reach their goals more easily.
In order to explain where the conventional wisdom goes wrong and how we should be thinking about it instead, I’m going to have to back up a little bit and make sure we all understand some of the basic definitions first. For that reason, this post will be a little longer than normal, but I hope you stick with me because the conclusion can make a big difference in your retirement planning.
What’s the difference between a Traditional IRA and a Roth IRA?
There are several ways in which a Traditional IRA differs from a Roth IRA, but today I’m only going to focus on the biggest difference. If you’d like a more comprehensive list, including guidelines for whether you are actually eligible to contribute to either one, you can check out this resource: Which IRA is right for you?.
The biggest difference between a Roth IRA and a Traditional IRA has to do with how they are taxed.
Traditional IRA taxation
Any money contributed to a Traditional IRA is treated as a tax deduction in the year of the contribution. This lowers your taxable income for the year, giving you an immediate benefit.
As an example, if you’re a married couple in the 15% tax bracket and you contribute the maximum $11,000 to a Traditional IRA for 2013, you will save yourself $1,650 in taxes for 2013 (0.15*11,000).
The flip side is that when you actually reach retirement and start taking money out of the account, those withdrawals will all be taxable.
Roth IRA taxation
The tax treatment for a Roth IRA is exactly the opposite.
Your contributions to a Roth IRA are not deductible and therefore do not save you any money on this year’s taxes.
On the other hand, your withdrawals in retirement are 100% tax-free. In other words, you pay your taxes now in order to be tax-free later.
Understanding different kinds of tax rates
The last thing I want to talk about before I get into the real meat of the comparison is the difference between a marginal tax rate and an effective tax rate.
Don’t worry, I’m not going to get too technical here. But understanding this difference is crucial to making a true comparison between a Traditional or Roth IRA.
Marginal tax rate
A marginal tax rate is the tax you will pay on your last dollar of income. If you’re in the 15% tax bracket, your marginal tax rate is 15%. Your last dollar earned was taxed at 15%, and if you earn another dollar it will be taxed at 15%.
Effective tax rate
But you didn’t pay 15% in taxes on your entire income. In fact, with the standard deduction and personal exemptions, there’s a good chunk of your income that you didn’t pay any tax on at all. And because of our progressive tax code, there’s another chunk of it that was only taxed at 10%. So your effective tax rate is the percent of your total taxes paid over your total income, and will be significantly lower than 15%.
Let’s look at a simple example of a married couple with 1 child earning $53,000 per year. Their marginal tax rate is 15%. But what’s their effective tax rate?
You can look at my worksheet here to see the calculations, but the end result is that the couple’s effective tax rate is only 6.5%.
So what’s the real Traditional vs. Roth IRA Comparison?
Okay, now that we’ve gotten all of those definitions out of the way, it’s time for the real meat of the article: how you should really be making the decision about contributing to a Traditional IRA vs. a Roth IRA.
Please keep in mind that this conversation applies in the same way if you have the choice between a Traditional 401(k) and a Roth 401(k).
The conventional wisdom behind the Traditional vs. Roth IRA comparison looks at your marginal tax rate today against your marginal tax rate in the future. This is wrong.
What you need to do instead is compare your MARGINAL tax rate TODAY with your EFFECTIVE tax rate in the FUTURE.
That’s because any contributions to a Traditional IRA save you money at your marginal rate today, but any future withdrawals are taxed at your effective rate.
Let’s look at an example. You can follow my calculations and change some of the variables in this workbook here: Traditional IRA vs. Roth IRA.
For this example, I’m going to assume that all of our tax policies will stay the same over the years. This clearly won’t happen, but since we have no idea what WILL happen it doesn’t really make sense to speculate. I’m also going to ignore inflation, which just makes things more complicated and doesn’t materially affect the end result.
Finally, I’m ignoring the possibility that you have a pension or that you will receive Social Security income, since most young people don’t have a pension and Social Security is not guaranteed. The existence of either of those would change the calculations below in favor of a Roth, though not necessarily fully in favor of it.
In this example we’re using the same married couple we used above making $53,000 with one child, which puts them in the 15% tax bracket. We’re assuming they could contribute the maximum $11,000 per year allowed for a married couple to a Traditional IRA. With a Roth they would have to pay taxes on that $11,000, so their annual contribution is only $9,350 ($11,000 * (1 – 0.15)).
The conventional wisdom says that the 15% tax bracket is low and they should therefore contribute to a Roth.
So how does it actually play out? Well, when we actually run the numbers, as you can see in the spreadsheet linked above, we discover a few things that really challenge the conventional wisdom.
First of all, after 30 years of saving for retirement the balance in the Roth IRA is $1,143,934. Using the standard 4% withdrawal rule to determine how much they can take out each year in retirement, that would give them a $45,757 annual income in retirement. That is 100% tax-free.
With the Traditional IRA, their balance after 30 years is $1,345,805. It’s about $200,000 higher because they were able to contribute more because of the tax-break. But the withdrawals are taxable, so that’s not the full comparison.
To get the final comparison, we have to first calculate the 4% withdrawal for the Traditional IRA, which comes out to $53,832 per year before taxes. Notice that this is almost the same as their $53,000 in income during their working years. (These numbers were not chosen by accident).
The conventional wisdom would argue that because your income is essentially the same, and therefore your marginal tax rate is the same, it shouldn’t make a difference whether you contributed to a Roth or a Traditional IRA. Does that hold up?
When we take taxes out of that $53,832 per year, we find out that our withdrawal ends up being $49,650 after-tax. So let’s do a quick comparison of the results:
I don’t know about you, but I would rather have that extra $3,893 of income every year.
What’s the reason for this difference?
The big reason why the Traditional IRA comes out ahead has to do with the difference between marginal and effective tax rates that we talked about above.
In this particular example, the Roth IRA contributions would be taxed at the MARGINAL rate of 15%, while Traditional IRA contributions would be tax-free.
At the other end, the Roth IRA withdrawals would be tax-free while the Traditional IRA withdrawals would be taxed at an EFFECTIVE rate of 7.8%.
So by going with a Traditional IRA in this example, the couple would essentially be choosing to pay 7.2% less in taxes, even though their marginal rate would be the same at each point in time. Over 30 years of saving that adds up to a significant difference.
Now let me be clear. This doesn’t mean that a Traditional IRA is always better than a Roth IRA. There are many variables that might make your specific situation different from the example shown here. Some of those variables will tilt the scales in favor of a Roth IRA. Others will tilt them in favor of a Traditional IRA. A true personal evaluation will be more nuanced than what’s presented here.
But what should be clear is that the conventional wisdom behind the Traditional vs. Roth IRA debate is wrong. You cannot simply compare your tax rate now to your expected tax rate in the future. Doing so drastically underestimates the value of a Traditional IRA.
One of the biggest financial decisions you will make is how to save for retirement. My hope is that this helps you make a more informed decision.
If you’re interested in learning more on this topic, you can check out these two articles I wrote as a follow-up: