Reasons for Roth IRAs

Investing

This submission is part of the NerdWallet 2013 Roth IRA writing contest. The views and recommendations presented in this piece are held by the individual contest participant and do not represent those of NerdWallet.

 

By Alexander Yuan

Retirement planning is crucial to an individual’s financial security, especially early on in one’s career.  I personally have a Roth IRA and would strongly recommend it to anyone looking to start saving for retirement.  It is important for people to set aside money for their retirement each year and the government provides tax incentives to do so through IRAs.  The optimal choice between a Roth and Traditional IRA is an often debated topic and depends on whether you believe you will end up in a higher or lower tax bracket in the future.  First, I will talk about the basic principle behind the Traditional and Roth IRA; then I will go through an example and work with some real numbers before summarizing the key points.

Traditional IRAs help you save on the differential in tax brackets between when you contribute and when you withdraw your money.  You put money in pre-tax and any interest, dividends and capital gains you make on your investments do not get taxed while still in the account.  When you withdraw the money out of your account, however, that money is taxed as if you earned it as income.  This means that the tax-deductibility of your contributions is not pure savings; instead, you can think of it as a loan from the government and you pay back that loan when you withdraw from the account.  The main benefit from this “loan” comes from falling into a lower tax bracket after you retire and getting taxed for that income at the lower rate.

A Roth IRA, on the other hand, only lets you contribute after-tax dollars each year but you get to withdraw all your money tax-free.  The beauty is in the simplicity.  This may seem like a big plus over the Traditional IRA, but the benefit of tax-free earnings actually cancels out with the Traditional IRAs tax-deductibility if the tax bracket is held constant.  While the Traditional’s “loan” gains value if you fall into a lower tax bracket, the Roth’s tax-free earnings gain value if you fall into a higher tax bracket.  This may happen if you are still working after turning 60 when you withdraw or if you foresee tax rates increasing in the future.

Let’s illustrate this with an example: assume you are 25 years old, earned $50,000 in 2012, will earn a 5% average annual return in your IRA, and your current tax rate is 25% and your marginal tax rate would be the same when you withdraw the money at age 60.  You are eligible to contribute up to $5000 to either a Roth IRA or Traditional IRA as of 2012 (but this is bumping up to $5500 in 2013).  For a traditional IRA, let’s deposit the maximum $5000 and earn 5% for 35 years which equals $5000 * 1.05^35 = $27,580.  Then, you withdraw the money and pay 25% in taxes leaving you with $27,580.08 * 0.75 = $20,685.  Not bad.  For the Roth IRA, you would have to pay taxes on the $5000 first and contribute $5000 * 0.75 = $3750.  That $3750 will also grow at 5% for 35 years: $3750 * 1.05^35 = $20,685.  And this is withdrawn tax-free so that will be your final total.  But wait a second… isn’t that the exact same result as the Traditional IRA?  If you contribute and retire in the same tax bracket, it doesn’t matter which account you pick (although you can contribute more money to a Roth IRA if you are maxing out your contribution).  If your ending tax bracket drops to 15%, however, you will end up with $23,443 with the Traditional vs $20,685 with the Roth.  If your ending tax bracket increases to 35% (through higher earnings or unfortunate tax policy changes) then you will end up with $17,927 with the Traditional vs $20,685 with the Roth.

 

Comparison between Roth and Traditional (2013, single/head of household)

Traditional

Roth

Tax-deductible contributions

Yes

No

Tax-free withdrawals

No

Yes

Contribution limit (pretax, 10% – 25% tax bracket)

$5,500

$6111 – $7333

Income limit to contribute

None

$127k (reduced after $112k)

Age limit to contribute

70.5

None

Option to convert into the other (rollover)

Yes

No

Required minimum distributions

At age 70.5

None

Penalty withdrawing early

Contributions and earnings – 10%

Only earnings – 10%

There are some other key differences to take note of when deciding between a Roth and Traditional, summarized by the above chart.  On average, the Roth IRA looks sexier than the Traditional IRA.  Our example compared a $5000 Traditional contribution with a $3750 Roth contribution to keep the pre-tax dollars the same, but you can still contribute up to $5000 to a Roth.  This means each year you can shelter more of your income for retirement tax savings with a Roth; over time this becomes a huge benefit.  You are also able to withdraw your contributions early without penalty and have some insurance against rising tax rates.  On the other hand, if you know you are going to stop working the moment you are allowed to withdraw from your IRA without penalty and fall to the lowest income tax bracket, a Traditional IRA may be the better fit.  And if you are really unsure, you can always open one of each.  But remember that at the end of all this, no matter what your tax savings are, having any savings for retirement is a step in the right direction toward securing better financial stability.