Paper or plastic? Mac or PC? Roth IRA or traditional IRA?
The first two choices are largely matters of personal preference, the third strictly of taxes — or so you’ve probably been told. But a NerdWallet analysis reveals that knowing whether to opt for the Roth over the traditional IRA is more nuanced than that. For those savers who want to maximize contributions, and who don’t separately invest their traditional IRA tax savings each year, the Roth is the better choice.
The Roth advantage in these circumstances is not trivial: In several tax scenarios in which traditional IRA tax savings are not invested, the after-tax value of the Roth stands six figures ahead of the value of the traditional IRA.
Rethinking old assumptions on IRAs
The general advice on IRAs goes this way: If your tax rate is lower now than you expect it to be in retirement, a Roth IRA — which offers no immediate tax deduction, but allows tax-free distributions in retirement — is the right choice for you, provided you don’t exceed the income limits for a Roth. If you expect your tax rate to drop in retirement, standard advice says to go with a traditional IRA, which offers a tax deduction on contributions now in exchange for taxed distributions later.
In the U.S., 25% of households have a traditional IRA, while only 17% have a Roth, according to 2016 data from the Investment Company Institute. Those numbers include all income levels; but at incomes that are currently eligible for participation in a Roth, the traditional IRA still leads by a significant margin.
While the NerdWallet analysis shows that Roth IRAs may make sense for many savers, particularly for those who make the maximum IRA contribution each year ($5,500, or $6,500 if you’re 50 or older), it is worth noting that lower contribution levels and different treatments of the traditional IRA tax savings can lead to outcomes that favor the traditional IRA.
Taxes now versus taxes later
Why does the Roth win so often? It relates to the value of a dollar in a Roth IRA compared to the value of a dollar in a traditional IRA. A dollar is a dollar, right? Not when that dollar is being taxed.
When you put money into a Roth IRA, you are depositing after-tax dollars, which means the contribution costs you more upfront: the amount of the contribution plus the taxes owed on those dollars.
With a traditional IRA, your money is going in pretax, which means your cost is only the amount of the contribution, plus you may get a tax deduction, depending on your income. That makes it seem like the traditional IRA is a better deal, and in the short run, it is.
But when you pull $30,000 out of a traditional IRA in retirement, the IRS gets a little piece of that pie — how little depends on your future tax rate, but several thousand dollars, to be sure. When you pull that $30,000 out of a Roth IRA, you’re putting $30,000 into your pocket because you paid the taxes up front.
How investing tax savings can help traditional IRAs
To account for that tax burden in retirement, a traditional IRA needs a larger balance to equal the value of a Roth IRA. And since the contribution limit on these accounts is the same — that $5,500 is a combined limit between the two — the only way to build that larger balance at the maximum contribution levels is to supplement it by contributing to a separate investment account.
To do that, you would need to take the tax savings netted by the traditional IRA contribution each year and put it in a brokerage account, choosing investments that mirror what’s in your IRA. At a 25% current effective tax rate and the maximum $5,500 contribution, that would mean investing $1,375 in tax savings from that tax deduction.
Investing 100% of the taxes saved makes the traditional IRA a more valuable option than the Roth IRA in some, but not all, tax scenarios — primarily at expected retirement tax rates of 20% or below. (For more details across tax rates, see the full NerdWallet study.)
If, on the other hand, you take that tax savings and absorb it into your budget — either because it simply reduces your tax bill come filing time, so you never actually get your hands on it, or because you didn’t know the importance of investing it — you would end up short of what you could have accumulated in a Roth IRA, no matter what your tax bracket. Of course, the traditional IRA tax savings have value even if those savings are not set aside for retirement — but this analysis centers on the after-tax-value of IRAs rather than overall cash flow.
Again, the figures in the analysis assume the saver is making maximum annual contributions. Savers who make less than the maximum contribution each year may find traditional IRAs more competitive for their tax scenario — or they may not. (NerdWallet’s Roth IRA vs. traditional IRA calculator can help you compare account values at your preferred contributions levels and expected tax rate.)
Another possible Roth upside: Roth IRA rules don’t require minimum distributions — mandatory withdrawals set forth by the IRS — but a traditional IRA owner must begin withdrawals at age 70½. That’s worth weighing if you want to pass money on to heirs.
The key issue for traditional IRA savers
According to the National Retail Federation, less than half of the people who expect to receive a tax refund in 2017 plan to save it. Statistics like this, combined with the nation’s meager 5.5% personal savings rate, suggest that many people who max out a traditional IRA may not also invest the tax savings they receive from that contribution.
So if you’re committed to making maximum annual contributions to your IRA, the choice between a Roth or traditional IRA requires an analysis of your own saving habits. If you choose a traditional IRA over a Roth IRA, you need to commit to saving that tax deduction each year to have a chance of coming out ahead.
Some very disciplined savers will be able to do that. But for the many others, the Roth IRA is the better choice.
» MORE: Estimate the value of your Roth IRA at retirement with NerdWallet’s Roth IRA calculator.
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.