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The Roth versus the Traditional IRA: an annual decision.

Most investors would quickly say that Roth IRAs are always better than Traditional IRAs because of the "tax benefit." Are they right? Sometimes a Traditional IRA will provide an investor with higher after-tax retirement benefits.

IRA Characteristics

Currently, both the Roth and Traditional IRAs have the same annual dollar contribution limits. Contributions to a Roth IRA are on an after-tax basis while those to a Traditional IRA are on a before-tax basis. The main selling point of the Roth IRA is that all withdrawals, including returns on the original investment, will not be subject to income taxes. The individuals using Traditional IRAs will have to pay taxes on the original investment and all the portfolio gains when the money is withdrawn. Most investors decide that the Roth IRA is obviously better because the money grows tax-free. One possible disadvantage to a Roth IRA is that it carries more rigid rules that keep savers from taking the money out early, whereas rules for Traditional IRAs allow early withdrawals, but with stiff tax penalties.

IRA Return Comparisons

The decision criterion that should be used in choosing an IRA is the maximization of after-tax retirement benefits. To determine the benefits of one type of IRA in contrast to another, equal before-tax contributions into portfolios with the same returns must be considered. Table 1 shows the Roth IRA has no advantage over the Traditional IRA if the investor's marginal tax bracket is the same during both the contribution years and the retirement years (for an equal before-tax contribution).

Table 1, Panel A, assumes a tax rate of 40% both before and after retirement. The tax on the Roth IRA investment is taken out before the money grows and the tax on the Traditional IRA investment is taken out after the money grows. The results for Panel A show that taxing the original investment is the same as taxing what the original investment would have grown to at that particular rate, regardless of age at the time of the contribution or returns on the investment.

Panel B shows the outcome when an investor's marginal tax rate falls during retirement. This analysis indicates that an investor in a higher marginal tax bracket at the time of payment into a Roth IRA ends up with less money during retirement as compared to a Traditional IRA if he/she is in a lower marginal tax bracket after retirement. Specifically, paying money into a Roth IRA when an investor is in a 40% tax bracket locks that investor into that tax rate. Therefore, if an investor expects to be in a higher marginal tax bracket during his/her earning and investing years than during his/her retirement years, the Traditional IRA provides higher after-tax withdrawals on an equivalent before-tax contribution.

Panel C considers the opposite situation, where the investor's marginal tax burden rises during retirement. This analysis shows that the Roth IRA provides superior after-tax returns compared to the Traditional IRA when the tax bracket during the earning years is lower than during the retirement years.

Implications

Based on the observations in Table 1, we can now determine the circumstances that would favor investing in each type of IRA.

In your early savings years, generally you expect to be in a lower tax bracket. Therefore, the Roth IRA would obviously be better because the tax rate is lower while you are earning less. Later in life, when you have moved into a high tax bracket, the Roth IRA loses some of its appeal. For instance, for an equal before-tax contribution of $3,000, investors would end up with less after-tax money if they pay 40% before contributing (Roth) than if they wait and pay only 30% while withdrawing (traditional). Therefore, for equivalent before-tax contributions, the Traditional IRA is better if the income earner is currently in a higher tax bracket than anticipated after retirement

The Roth IRA does have a redeeming feature above and beyond the Traditional IRA, even when the investor is in the same tax bracket before and after retirement. The Roth IRA effectively increases the allowable before-tax contribution to the IRA. Because the maximum contribution to the Roth is the same as that of the Traditional IRA (currently $3,000), an after-tax $3,000 contribution to the Roth for an investor in a 40% tax bracket is equivalent to a before-tax contribution of $5,000 to a Traditional IRA (i.e., $5,000 minus 40% taxes equals $3,000). Therefore, the after-tax contribution feature of the Roth would allow an individual to save more money toward retirement, other things being equal.

Summary

This analysis helps financial planners and individual investors decide which type of IRA would maximize after-tax withdrawals and after-tax returns on IRA investments. Because equivalent before-tax contributions result in equivalent after-tax withdrawals for individuals in the same tax bracket before and after retirement, the Roth IRA has no advantage over the Traditional IRA. In fact, if a client's marginal tax bracket was to fall from the savings years to the withdrawing years, the Traditional IRA would provide the individual with a higher after-tax benefit than the Roth IRA for equivalent portfolio performance. Thus, the decision about which type of IRA to use is one that should be reconsidered on an annual basis. In those years where the investor's current marginal tax rate exceeds the anticipated marginal tax rate during retirement, the Traditional IRA provides superior retirement benefits. In those years where the investor's current marginal tax rate is anticipated to be lower than the marginal tax rate during retirement, the Roth IRA is the better choice.

The advantages of the Roth IRA over the Traditional IRA are twofold. First, in a client's early saving years when he/she is earning less money and is in a low tax bracket, the Roth provides higher withdrawals during retirement than the Traditional for the same before-tax contributions (because the Roth locks the payment and related gains into the current tax rate). Finally, because both the Roth and Traditional IRAs have the same maximum contribution limits, the Roth IRA effectively increases the total amount of before-tax money that can be saved.
TABLE 1

Roth IRA Versus Traditional IRA, With Before-Tax Equivalent
Contributions

 ROTH AT ROTH VALUE
 ANNUAL TODAY'S PAYMENT ON AFTER TAX AT TRADITIONAL BT
AGE RETURN TAX RATE $3,000 65 PAYMENT

PANEL A

25 10 40% 1800 81466.66 3000
30 10 40% 1800 50584.39 3000
35 10 40% 1800 31408.92 3000
40 10 40% 1800 19502.47 3000
45 10 40% 1800 12109.50 3000
50 10 40% 1800 7519.05 3000
55 10 40% 1800 4668.74 3000
60 10 40% 1800 2898.92 3000

PANEL B

25 10 40% 1800 81466.66 3000
30 10 40% 1800 50584.39 3000
35 10 40% 1800 31408.92 3000
40 10 40% 1800 19502.47 3000
45 10 40% 1800 12109.50 3000
50 10 40% 1800 7519.05 3000
55 10 40% 1800 4668.74 3000
60 10 40% 1800 2898.92 3000

PANEL C

25 10 30% 2100 95044.44 3000
30 10 30% 2100 59015.12 3000
35 10 30% 2100 36643.75 3000
40 10 30% 2100 22752.88 3000
45 10 30% 2100 14127.75 3000
50 10 30% 2100 8772.21 3000
55 10 30% 2100 5446.86 3000
60 10 30% 2100 3382.07 3000

 TRADITIONAL TRADITIONAL
 VALUE BEFORE TAX RATE AT VALUE AFTER
AGE TAX AT 65 65 TAX AT 65

PANEL A

25 135777.77 40% 81466.66
30 84307.31 40% 50584.39
35 52348.21 40% 31408.92
40 32504.12 40% 19502.47
45 20182.50 40% 12109.50
50 12531.74 40% 7519.05
55 7781.23 40% 4668.74
60 4831.53 40% 2898.92

PANEL B

25 135777.77 30% 95044.44
30 84307.31 30% 59015.12
35 52348.21 30% 36643.75
40 32504.12 30% 22752.88
45 20182.50 30% 14127.75
50 12531.74 30% 8772.21
55 7781.23 30% 5446.86
60 4831.53 30% 3382.07

PANEL C

25 135777.77 40% 81466.66
30 84307.31 40% 50584.39
35 52348.21 40% 31408.92
40 32504.12 40% 19502.47
45 20182.50 40% 12109.50
50 12531.74 40% 7519.05
55 7781.23 40% 4668.74
60 4831.53 40% 2898.92


Terry Bechtel is a CPA and Assistant Professor of Accounting at Northwestern State University of Louisiana in Natchitoches. His area of expertise is tax planning and accounting. Mark Schaub is Assistant Professor of Finance at Northwestern State University of Louisiana. His previous research has been in the areas of consumer finance, international investments and stock market efficiency.
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Author:Bechtel, Terry; Schaub, Mark
Publication:The National Public Accountant
Date:Jul 1, 2003
Words:1453
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