The Age Old Battle of the IRAs

Posted on: April 21, 2013 by Martin Curiel, CFA in Tax Strategy

Roth IRAs and Traditional IRAs can be important retirement planning tools. However, it is not always clear which account is most efficient. Investors must consider multiple factors, including their marginal tax rate before and during retirement and the likelihood of the government changing the tax laws that affect how these accounts are treated.

Skipping to the conclusion – there is no clear winner. Both have advantages/disadvantages that make one better than the other in certain situations
However, there is a lot of confusion about those differences. First, many focus on the fact that all gains in the Roth IRA are tax-free, whereas all gains in the Traditional IRA are taxed when withdrawn. Since there can be large gains in the account, the total taxes paid using a Traditional IRA can be quite large, which makes the Roth IRA appear superior.
However, assuming the marginal tax rates are the same at the time of contribution and the time of withdrawal, both provide the same after-tax benefit, regardless of investment returns. This is surprising to a lot of people, but it is really quite simple if you take a look at the following equations:

  • Roth IRA withdrawal= (Pre-tax income) * (1 – tax rate at time of contribution) * (1 + growth rate)
  • Traditional IRA withdrawal = (Pre-tax income) * (1 + growth rate) * (1 – tax rate at time of withdrawal)
If the marginal tax rates are the same and the growth rates are the same (here we define “growth rate” as the total over the period, not the annualized return), then the after-tax withdrawal amounts will be the same. Some say, “I want my risky, high-potential-return investments in the Roth and my safer ones in the Traditional IRA or 401(k),” but it really does not matter in the case of equal marginal rates. As we will discuss in future articles, there are indeed reasons to differentiate investments between tax-deferred accounts and fully taxable accounts, but not between Roth IRAs and Traditional IRAs.

The key assumption here is that the marginal tax rates are the same. Some people expect the government to raise tax rates, making the Roth IRA superior. However, incomes when working are typically much higher than incomes when retired. So, the marginal tax rate is often higher when working, which would mean that the Traditional IRA could be superior even if tax rates are increased. For example, under the current structure, the marginal tax rate may be 35% when working and 28% when retired. If those rates are changed to 38% and 31% respectively, the rates increased, but the marginal rate when retired (31%) is still lower than the marginal rate when working (35%). Another point to keep in mind is that the government could increase other types of taxes, such as a national sales tax or a national property tax, keeping income tax rates steady – or even decreasing them.

Some people avoid the Roth IRA because of a fear that the government will change the rules to later tax Roth IRA withdrawals. We do not expect that this will occur. If the laws are changed regarding tax withdrawals, it is most likely that only the gains would be taxed, but even that would be a major change. A more likely change is that the government will require distributions to be made from the Roth IRA, just like they are required from the Traditional IRA.

The main benefit of the Roth IRA is for those who want to maximize contributions. The limits are based on the amount contributed, and the Roth IRA contribution is made with after-tax dollars. So, the maximum pre-tax contribution for a Roth IRA is higher than that for a Traditional IRA. For 2013, the AGI limit for contributing to a Roth IRA is $188,000 (phase-out starts at $178,000) for married filing jointly or $127,000 (phase-out starts at $112,000) for single. For those over the limit, it’s simple – the Roth IRA is not an option, so the Traditional IRA or 401(k) is better.

For those under the AGI limit, we think most people would be better off with the Traditional IRA because the marginal tax rate is likely to be lower in retirement than while working.

To summarize our observations:

Inefficient Strategies
  • Assuming that one type of account is always better than the other
  • Failing to maximize the contribution and/or failing to see the after-tax benefit associated with doing so
  • Not fully understanding the tax assumptions implied with the decision to funding a particular account type
Efficient Strategies
  • Maximizing the contribution allowed – at the end of the day, there will be a tax benefit from either account type
  • Funding a Traditional IRA if the investor is likely to be in a lower tax bracket during the retirement years (most will fall into this category)
  • Funding both types of accounts if the investor is very unsure of what his/her situation will be in retirement or does not want to make any assumptions about future tax law changes

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