Friday, March 09, 2007

IRA Choices - Roth or Traditional?

All IRAs provide for tax free earnings. Some IRAs have additional tax benefits, either at the beginning (contribution) or at the end (withdrawal). Deciding which IRA to use will depend on whether one wants the additional tax benefit earlier or later. Here is how I see the choices.

Deductible Traditional IRA - If qualified for this IRA, the entire contribution (maximum $4000 per person) is deductible from one's taxes. For people in the 25% tax bracket, a $4000 deductible IRA contribution will results in a $1000 tax refund. A deductible traditional IRA is a great way to use other people's money to fund one's retirement. For details on qualifying for a deductible IRA contribution see 2006 IRA Contribution Deadline is April 17, 2007.

Withdrawals from a deductible traditional IRA are fully taxable.

Roth IRA - Contributions to a Roth IRA are not deductible. However, withdrawals from a Roth IRA during retirement (after 59 1/2) are federal income tax free.

The idea of paying zero taxes is very appealing to me :-) On the surface, this seems like the better deal to me.

Which is the better financial choice - a Roth or Deductible Traditional IRA? To determine the answer, I looked at two situations. In both situations, I assume that the retiree will need 100% of their pre-retirement income and therefore, have the same tax rate (25%) before and after retirement. Also, I assume earnings of 10% over 30 years in both taxable and non taxable accounts.

In the first situation, I assume that the person needs to spend the tax savings. Thus, they invest $1000 less in the Roth IRA, which is equivalent to the tax savings of the deductible IRA. This case shows no difference between the two types of IRAs.

Spend Tax Savings
IRA TypeContributionTax Rate After Tax Value
Traditional$4000 25%$20182.5
Roth$30000%$20182.5
Difference$0


In the second situation, I assume they invest the tax savings in a taxable retirement account. This example shows that the Roth IRA will have about 10% higher earnings return, over 30 years. The reason is that the $1000 invested in a taxable account will not earn as much as investments in the tax deferred accounts.


Invest Tax Savings
IRA TypeContributionTax Rate After Tax Value
Traditional$4000 25%$24430.35
Roth$40000%$26910
Difference-$2479.65


Of course, if future tax rates are lower (not likely) or Roth IRAs become taxable (more likely) the conclusions from these analyses will be more favorable for the deductible IRA.

Finally, the actual best choice will depend on each person's own financial situation. Please consult your personal financial advisor before taking any action.

For more on Reaping the Rewards, check back every Friday for a new segment.

This is not financial advice. Please consult a professional advisor.

Copyright © 2007 Achievement Catalyst, LLC

6 comments:

MossySF said...

I read some recent article about Traditional vs Roth IRAs where the analogy was "bird in the hand versus 1.2 in the bush". Sometimes it's better to get whatever you can now because who knows what future presidents/congresses will do.

Super Saver said...

MossySF,

Thanks for your comment.

You make a very good point. No argument from me on choosing to go for the sure savings. Legislation can't elminate a tax break that has already been taken:-)

Dimes said...

As a person with a lot longer than 30 years to invest, I go with the Roth. However I'm not confident that they're going to keep it tax free. Of course with an effective tax rate of <10% right now it's a risk I'm willing to take. David Bach thinks they're going to make 401ks not taxable, but he's full of hot air.

Super Saver said...

Dimes,

Thanks for your comment.

I personally also like the Roth the best. I had not heard about David Bach's claim about 401Ks. Interesting, and I agree it seems unlikely.

Anonymous said...

If Congress decides to mess with our tax-free earnings in 30-years, we will have no one to blame but ourselves...

We elect these empty suits....And by that time, a senator who serves one term will get an annual pension worth 100K, free health care for life anmd will probably be making $200K per year during his term...

Is there anything in the past that would lead folks to believe that Congress would take away our hard earned money from a tasx shelter they set up?

Super Saver said...

Anonymous,

Thanks for you comments.

I agree that there is a possibility that a law change may eliminate the tax benefits of IRAs. I think it is a small possibility, but a possibility nevertheless.