Conventional wisdom suggests that a Roth IRA is better for those with a higher income tax bracket in retirement than in their working years, while a traditional IRA favors those who occupy a lower bracket in retirement. But a new study suggests that isn’t always so.
According to the NerdWallet report, the margin of victory for the Roth is significant. 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. In one tax scenario, the Roth IRA adds more than $180,000 in after-tax retirement savings.
NerdWallet explains that since Roth IRA contributions are made with after-tax dollars, in order 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. If you put $5,500 into a traditional IRA, that money goes in pretax, which means the cost is $5,500 (assuming you’re eligible for a deduction), that makes the traditional IRA a better deal in the short run, and may well be why many savers choose a traditional IRA.
The report says that in order to evaluate these accounts fairly, you need to compare the Roth IRA balance at retirement to the after-tax balance of the traditional IRA. For example, when $30,000 is withdrawn from a traditional IRA, the IRS takes a cut (exactly how much depends on a variety of factors), but when $30,000 comes out of a Roth IRA in retirement, that $30,000 reaches the retiree free of taxes.
Among other key findings of the report:
- Equal contributions always favor the Roth. The analysis finds no tax scenarios in which the value of a traditional IRA at retirement beats the value of a Roth IRA, assuming the investor makes the maximum $5,500 annual contribution.
- 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, who stand to net an additional $184,364 over a 30-year period.
- Investing tax savings can help the traditional IRA — sometimes. 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. However, the report claims that even if an investor were to invest 100% of the tax savings from each annual traditional IRA contribution, most tax scenarios still favor the Roth IRA.
- Roth IRAs win in shorter time frames, too. The advantage for Roth IRAs also appears in scenarios in which the saving period is shorter — say, 10 years instead of 30 years — though the benefit is generally smaller.