Should You Invest In An IRA or A Roth IRA?

June 21, 2018

  • There is very little mathematical difference between an IRA versus a Roth IRA. Ultimately, the retirement benefit you receive will be the same assuming your tax bracket never changes.
  • If you tax bracket is lower after retirement, and traditional IRA or traditional 401(k) will provide superior retirement income.
  • If your tax bracket is higher after retirement, a Roth IRA or Roth 401(k) will be better.
I’ll leave more detailed explanations of what IRAs and Roth IRAs are for other articles. This article is a mathematical comparison of the differences between a standard IRA and a Roth IRA. Both IRAs and Roth IRAs are powerful tools that everyone interested in saving for the future should be using, even if your goal is not retirement specifically. If your savings goal is past age 59 ½, the benefit of tax-deferred growth of your investment funds is undeniable.
Traditional IRA versus Roth IRA

Choosing depends on your goals

Choosing between an IRA versus a Roth IRA just depend on your investment goal. Most people I consult with are going to end up doing an IRA because they are trying to reduce their taxes now. IRAs are deductible against your current income. If you make $50,000 and contribute $5,000 to an IRA, your taxable income drops to $45,000. Simple as that.

A Roth IRA, on the other hand, give you no current tax break. Assuming you are at a 25% Federal and State combined tax rate, and you earn $50,000 a year, that same $5,000 would be taxed. 25% of $5,000 is $1,250 which goes to the government. Therefore, you would only have $3,750 left to invest in a Roth. So why invest in it? A Roth IRA is one of the few investments under U.S. law that is completely tax free, no matter how much growth you receive in the future. The IRA would be taxable upon withdrawal.

So, do you want a tax break now, or in the future? That’s the decision.

Is there a mathematical difference between an IRA and a Roth IRA?

The above graphic can be used to compare IRAs to Roth IRAs, but also 401(k)s to Roth 401(k), or any tax-deductible investment compared to an investment that is non-deductible but tax-free upon withdrawal. Sticking with the example above, let’s say you are at a 25% combined Federal and State tax bracket and you stay there, even after retirement (more on that below). The graphic then assumes that you contribute $5,000 a year for 15 years, then withdraw an equivalent amount for the next 15-years until your account is depleted.

First off, in the IRA, you can contribute the full $5,000 a year. To the Roth IRA though, you need to pre-pay your tax at 25%, so you would only be able to contribute $3,750 a year. With both accounts growing at 6% tax deferred, the IRA seems to have an advantage. By year 15, the IRAs account value is $123,363 which would allow you to withdraw $12,000 a year and not run out of money for 15 years. The Roth IRAs account value is only $92,522 allowing you to withdraw only $9,000 a year for 15 years.

But, there is a catch. The Roth IRAs distribution is completely tax free. The IRA is taxed as income. Assuming you are at the same tax rate, 25%, the $12,000 IRA withdrawal is only worth $9,000 a year, the same as the Roth.

Therefore, assume no change in tax rate, there is no mathematical difference between an IRA and a Roth IRA. If your tax rate in the future is less than 25%, the IRA will be worth more. If your tax rate is greater than 25%, the Roth IRA will be worth more.

But won’t I bet at a lower tax bracket after retirement?

Most planners and most investors seem to assume that they will be at a lower tax bracket after retirement. After all, you don’t need to make as much after retirement since your kids are grown and on their own and your mortgage is paid off. Additionally, you’re not siphoning off a portion of each pay check to fund retirement, you’re retired already!

So, is this likely that you’ll make less? I’ve got some issues with the idea.

Why are you planning – do you really want to make less?

I don’t want to make less in the future, I want to make more. To me, planning is about building real wealth, and retiring not because I have reached a magic age, but because I have reached a financial level that is well beyond where I am now.

What about your deductions?

Even if you really do retire on less income, and you can afford to because your kids are moved out and your mortgage is paid off; remember those things are the sources of your deductions. With no child tax credits or mortgage interest deduction, you could very well find yourself at a higher tax bracket, even with less income.

What is the Federal government going to do with taxes?

Many investors mistakenly assume that taxes won’t change. But taxes are always changing. 2018 tax law was a major overhaul of the tax code. Where are taxes going in the future. Our Federal government has massive debt, huge annual budget deficits which are getting worse every year, underfunded pensions and entitlements, and an economy that is not growing quickly compared to past decades.

Bottom line

There is not mathematical difference between an IRA and a Roth IRA. You need to decide why you are investing and go with the option that best suits your goals. If you are trying to reduce current taxes and want to deal with the future when it comes, then go with the IRA. If you are like me and are willing to sacrifice a little now to make your future better, go with a Roth. Bottom line – do something! The $5,500 per year contribution allowance is too good of a deal to pass up. Even if you can’t afford to invest the full $5,500, invest what you can. If you really can’t decide between the two, split the difference. Put $2,250 into an IRA and $2,250 into a Roth IRA.