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Deciding between the Roth and the Traditional IRA is difficult. I am here to make it an easier decision for you.
I have taken a look at the pros and cons of each IRA and look at total value upon withdrawal to determine which one is best.
I was recently talking with a coworker about my switch from Roth IRA savings to Traditional IRA savings to take advantage of pre-tax contributions benefit now. His thought was to go with the Roth IRA because of the ease of withdrawal and tax-advantages at retirement age. I argued that the value of my Traditional IRA would be higher at retirement than his Roth IRA would, but I didn’t have data to back it up. This resulted in me modeling the final value difference at retirement between the Traditional and Roth IRAs.
First off, to set the expectations of my conclusions drawn, we need to go over the assumptions made during this analysis.
- Growth in the portfolio is set at 7%. This value does affect the results somewhat when varied, but 7% growth is a reasonable number. The values of the results will change, but the conclusions remain the same.
- The tax savings bracket for contributions is the highest bracket you are taxed in. In other words, if you are currently taxed in the 25% tax bracket, then the additional tax savings are 25% of your IRA contribution.
- All tax savings from Traditional IRA contributions are reinvested in a brokerage fund getting the same 7% growth in the portfolio.
- Inside the brokerage fund, you are only investing in index funds and holding until retirement. You are not generating capital gains or losses and you are not trying to increase your basis by buying and selling. Your basis in the brokerage fund is your contributions and nothing else.
- Upon withdrawal, I made a simplifying assumption for taxes. The entire amount of the withdrawal is taken at the tax rate shown. It is not calculated in the step-wise function that taxes are normally calculated in order to decrease the complexity of the calculation.
- For every year shown you contribute the same amount to the IRA and Brokerage account, and at the end of time, you withdrawal all of your money at one time at the given tax rate.
These assumptions were taken to make the calculations doable and reasonable. They are all worst case scenarios and with careful planning and withdrawal strategies, you can get much better returns than shown. The percent difference in account values will never be lower than shown. Let me know if you think these assumptions are not valid.
Traditional vs Roth IRA Value
Below is a graph that shows the percent difference in account value after-tax over a 30 year period of contributions for Traditional vs Roth IRA contributions. Positive percentages are favorable to Traditional IRA and negative percentages are favorable to Roth IRA.
As we can see in the above plot of %-difference between Traditional and Roth IRA values, if you have a retirement tax bracket of 10% or 15%, having come down from a higher bracket than you will be in a better position by using the Traditional IRA and putting the extra savings into a brokerage account to amass more money.
The results seem reasonable because of the percent difference between tax brackets. The higher the initial tax bracket you are in, the lower the percent difference between tax brackets. In other words, the % difference between 33% and 28% is 15%, while the % difference between tax brackets 15% and 10% is 33%. While both changes in tax brackets give an absolute change of 5%, the actual % change is much larger for the lower brackets.
Because the % change in tax brackets is higher when your initial tax bracket is lower, we see a much better yield with a retirement tax bracket of 15% or lower.
I believe it is a very reasonable assumption to have a lower tax bracket in retirement than in your working years. If you are currently making $100,000 as a family, then you are currently in the 25% tax bracket. If you are looking to retire early, are you really going to spend more than $77,000 per year? In retirement, when you no longer have to travel back and forth to work and spend money to make money, your expenses will almost certainly lower. It seems reasonable to assume a lowering of tax bracket upon retirement. The general advice we find online for retirement is you need 70-90% of your pre-retirement income. Even if that is true, which most certainly it should not be, you are going to have lower expenses and probably a lower tax bracket.
This graph is presented as percent difference so we can compare the relative merits of the 2 IRAs over time. The absolute difference becomes larger and larger even as the % difference decreases because of the increased account value. For example, let’s look at the 15-10% tax bracket reduction at 30 years. The Traditional IRA + brokerage option after-tax value would be $540,193 while the Roth IRA option would be $519,534, making a total difference for the Traditional IRA $20,659.
The Best IRA Type
The best IRA you can use is the Traditional IRA. It allows tax savings now, and those tax savings can be added to your brokerage account to also grow for retirement. At retirement, if you spend at or below the 15% tax bracket (should be very easy for married filing jointly), then you will come out way ahead.
When to Not Use the Best IRA
As we can see from above, the Traditional IRA has a major advantage over the Roth IRA in terms of long-term account value, but when should we not use the best IRA?
The Traditional IRA has its limits. The first limit is it has an income max for making deductible contributions. This limit changes per year but is fairly low for those of us that have a work sponsored retirement plan as well. My current max income to contribute to the Traditional IRA is an AGI of $99,000. If you are over this and are making after-tax contributions, you should be contributing to the Roth.
Basically, if you are ineligible to contribute to the Traditional IRA, then you should go for the Roth. If you are above the Roth IRA contribution level, then you should contribute non-deductible to the Traditional IRA and then do a backdoor Roth.
Also, if you truly believe you need to spend the same amount in retirement as you do in your working life, or your tax bracket in retirement is going to be 25% or higher, then you should contribute to the Roth. For us mere mortals, the Traditional IRA will be the best path.
There are other rules and regulations surrounding both of these IRA types that will be explained in future posts.
For those of us in the pursuit of freedom, the Traditional IRA is an amazing tool to add to our arsenal. It allows us to save more money now, reduce our current tax liability and result in higher after-tax value than the Roth IRA at retirement. Both IRAs, Traditional and Roth, have their place in society since not everyone can qualify for Traditional IRA use. For those of us that do qualify, we should use the Traditional IRA to boost our savings and achieve freedom sooner.
Check out all the calculations for yourself and play with your own numbers. Get the spreadsheet I used for these calculations FREE!
Which IRA do you invest in? Let me know in the comments.