For Savers Who Maximize IRA Contributions, the Roth Pays Off

Investing, Roth IRA
The Six-Figure Mistake IRA Savers Unknowingly Make

A NerdWallet analysis finds that savers who make the annual maximum contribution to their individual retirement account are likely to net more after-tax retirement dollars in a Roth IRA than in a traditional IRA. The numbers show that the Roth favors those savers more than conventional wisdom would suggest, and the differences are most extreme when tax savings from the traditional IRA contributions are not also separately invested themselves.

The analysis examines outcomes based on $5,500 annual contributions to each account. Because Roth IRA contributions are made after taxes are paid, and therefore represent a larger upfront savings commitment than traditional IRA contributions, the Roth generally leads to higher after-tax IRA values in the long run. To adjust for that after-tax advantage of the Roth IRA, a traditional IRA saver should invest the tax savings from each year’s contribution. For more on the tax treatment of these accounts and to see how the accounts compare when the traditional IRA tax savings are invested, see the “Doing the math: Roth IRA vs. traditional IRA” section below.

The margin of victory for the Roth is significant in some cases: The study finds several scenarios in which the take-home value of a Roth IRA at retirement is more than $100,000 higher than that of a traditional IRA that received the same contributions ($5,500 each year) over a 30-year investment period.

Key findings

  • Maximum contributions always favor the Roth if traditional IRA tax savings aren’t invested separately. The analysis finds no tax scenarios in which the value of a traditional IRA at retirement beats the value of a Roth IRA, assuming both accounts receive maximum contributions and the traditional IRA tax savings aren’t invested in a separate investment vehicle.
  • Investors who pay the highest tax rates in retirement stand to benefit (or lose) the most. The additional value amassed in Roth IRAs is most significant for investors facing the highest effective income tax rates at retirement; they stand to net an additional $184,364 over a 30-year period.
  • Investing tax savings can help the traditional IRA. If you invest 100% of the tax savings from each annual traditional IRA contribution, most tax scenarios still favor the Roth IRA. It is worth noting, however, that savers with very high tax rates during their careers and very low rates in retirement can also come out significantly ahead with a traditional IRA if they reinvest their tax savings — see the tables below for details.

Doing the math: Roth IRA vs. traditional IRA

Roth IRA contributions are made with after-tax dollars, which means every contribution has a higher effective cost: To make a $5,500 contribution — the current annual contribution limit — at a tax rate of 25%, you’ll also have to pay an additional $1,833 in taxes. (Learn more about Roths with NerdWallet’s Roth IRA explainer.)

If you put $5,500 into a traditional IRA, that money goes in pretax, which means the cost to you is $5,500. If you’re eligible for a deduction, the cost is offset by the value of that tax savings. That makes the traditional IRA a better deal in the short run. And it’s likely one reason why most savers opt for a traditional IRA. According to 2016 data from the Investment Company Institute, 25% of U.S. households have a traditional IRA, while only 17% have a Roth. Even though those numbers include all income levels, among those who meet Roth eligibility limits, the traditional IRA still leads by a significant margin.

When everything regarding taxes is considered, the question of which account will net a higher after-tax balance may hinge on whether the saver invests the traditional IRA tax savings each year. When $30,000 is withdrawn from a traditional IRA, the IRS takes a cut; exactly how much depends on unknown future tax rates, but will likely be several thousand dollars. But when $30,000 comes out of a Roth IRA in retirement, the full $30,000 reaches the retiree because the taxes were already paid when the contribution was made.

It is worth noting that traditional IRA tax savings have value even if those savings are not invested. Indeed, those tax savings can be a valuable addition to an emergency fund, or they can help pay down debt or loosen monthly cash flow. This analysis, however, focuses on the after-tax value of IRAs, not overall cash flow.

When the saver invests the traditional IRA tax savings

Because the contribution limit on these accounts is the same — $5,500 is the combined annual maximum for all IRA contributions — there is one way to possibly make a traditional IRA competitive with a Roth IRA in the case of maximum contributions: Invest the tax savings netted by the traditional IRA contribution in a separate investment account. That supplemental brokerage account should be invested in a way that mirrors the investments in the IRA. (Note that in scenarios in which the saver doesn’t make the maximum annual contribution to a traditional IRA, investing the tax savings may not require opening a separate brokerage account.)

In some scenarios, particularly in which the retiree’s tax rate stays at 25% or below, investing 100% of the taxes saved makes the traditional IRA a more valuable option than the Roth IRA. IRS data show that the majority of American taxpayers fall into brackets at or below the 25% level.

In other tax scenarios — specifically at lower current tax rates and higher projected retirement tax rates — investing 100% of the savings from a traditional IRA deduction yields a lower overall retirement balance than investing in a Roth IRA.

When the saver doesn’t invest the traditional IRA tax savings

This is when the Roth IRA really outshines the traditional IRA. The table below shows how much more a Roth IRA nets over the traditional IRA across various tax scenarios at the maximum annual contribution level of $5,500.

Note in the graph below that it doesn’t matter what the saver’s pre-retirement tax rate is in these scenarios. Because the traditional IRA tax savings aren’t invested each year, it’s solely the tax rate in retirement that impacts the outcome.

 

Try various Roth IRA and traditional IRA tax scenarios with the calculator below.

A simple choice for (most) savers

The bottom line: Savers who make the maximum annual contribution to an IRA and don’t separately invest traditional IRA tax savings will always end up with more take-home IRA savings at retirement if they choose a Roth IRA over a traditional IRA.

To make sure you’re on the right path with your retirement investment, follow NerdWallet’s IRA tips:

  • Take advantage of employer matching dollars. Before contributing to a Roth or traditional IRA, investors who are offered a retirement plan at work, such as a 401(k), should contribute enough to that plan to earn employer matching dollars.
  • Choose the right IRA provider. When deciding where to open your IRA, consider the broker’s account fees and investment selection, including the number of no-transaction-fee mutual funds and commission-free exchange-traded funds offered. When selecting investments, pay attention to expense ratios, which are annual operating costs of those funds paid by the investor.
  • Understand the rules for distributions. Taking money out of an IRA before age 59 1/2 can trigger a 10% penalty and income taxes. The Roth IRA is more flexible — contributions, but not investment earnings, can be removed at any time — but it’s important to remember that this money is earmarked for retirement and shouldn’t be tapped before then.

Arielle O’Shea is a staff writer at NerdWallet, a personal finance website. Email: aoshea@nerdwallet.com. Twitter: @arioshea. Jonathan Todd is a data analyst at NerdWallet. Email: jonathan.todd@nerdwallet.com.

This article has been revised to better clarify the impact of investing tax savings from traditional IRAs, which results in several scenarios in which the traditional IRA outperforms the Roth. It also clarifies that the Roth outperforms the traditional IRA by the largest margins when the saver makes maximum annual contributions and there is no investment of traditional IRA tax savings.

An earlier version of the first table and the calculator in this article overestimated the tax burden of investing the savings from a traditional IRA in a separate brokerage account. The calculator has been updated so the calculations don’t tax the investor’s contributions to the taxable account upon withdrawal, and additional detail has been added to the methodology.


METHODOLOGY

To determine the annual contributions to a Roth IRA versus contributions to a traditional IRA and brokerage account, we used the pretax value of a Roth IRA contribution, then calculated an equivalent investment in a traditional IRA plus any tax savings for investing.To make a $5,500 contribution to a Roth IRA with a tax rate of 25%, the pretax cost is $7,333. For the same amount, the saver can invest $5,500 in a traditional IRA, and have $1,833 pretax dollars remaining. After taxing that $1,833, the saver will have $1,375 remaining to invest in a separate, taxable brokerage account.

These figures were used as annual contributions to determine the value of each investment choice, assuming a 6% annual return, over a 30-year period. We also calculated different scenarios in which the percentage of the invested amount of the tax savings is adjusted.

The retirement portfolio consisting of the traditional IRA and brokerage account investments are taxed at an assumed retirement tax rate, while the Roth IRA is taxed only in the year of contributions.

The capital gains tax rate was factored into the effective tax rate expected at retirement. The total tax rate on the portfolio is dependent on other factors, such as the mix of investments in the portfolio and tax treatment of bonds.

Investments in the taxable brokerage account will likely incur taxes each year (for example on dividends as well as on capital gains distributions from turnover in the taxable portfolio), dragging down the overall after-tax return of both the taxable account and traditional IRA. Because these costs can vary widely based on the asset allocation of the taxable account, they are not built into these calculations. We recommend factoring in your expected after-tax return when comparing accounts.

NerdWallet compared the value of the traditional IRA after income-tax owed on withdrawals during retirement plus the value of the taxable account after capital gains tax owed upon sale of the taxable assets at retirement to the value of the Roth IRA during retirement. The appropriate taxes were factored into this calculation, including capital gains at 15% on taxable assets.

All numbers are inflation adjusted.