Traditional vs. Roth IRA

Rather than their age, I think the "starting out" aspect weighs in favor of Roth during the early years of their careers. All of this requires a reliable crystal ball to some extent, but one thing I think will hold true is that income taxes will remain progressive. Thus a tax deduction has less value early on that it will later in life. An extreme example is a dependent student working part time and earning less than the dependent's standard deduction. There would be no tax benefit from a traditional contribution and all those years of tax-free accumulation in a Roth.

-- Phil Marti Clarksburg, MD

Actually, the situation still favors the traditional IRA, but only by a small amount. The reason for this is that withdrawals from a Roth IRA are not completely tax-free, they are tax-free up to the amount(s) contributed, and thereafter are included in income. Thus, in your example, at retirement, the Roth would have a gross value of $10,722.59, the first $2,400 could be withdrawn tax-free, and the remaining $8,322.59 would be subject to tax at 20% (based on your assumption), leaving a net after-tax value to the Roth of $9,058.07. By comparison, the traditional IRA would have a gross value of $13,403.23, and a net after-tax value of $10,722.59. Thus, the traditional IRA provides $1,664.52 in additional future benefit over the Roth IRA. The Roth IRA really only provides a benefit over the traditional IRA if you're in one of the lowest tax brackets at contribution, and in the highest tax bracket at the time you withdraw the amounts at retirement. Even so, the benefit is not great. For example, if you had an effective tax rate of 5% at contribution, and an effective tax rate of 35% at retirement when you withdrew the full amount, the Roth would only provide you with an additional $561.89 in future benefits over the traditional IRA. In this case, unless the contributor's current effective tax rate is 0%, the "right" answer is a traditional IRA if that is an available investment. However, even though a Roth is not as good as a traditional IRA, it is definitely better than the alternative of a fully taxable investment, unless you can be certain that you will hold the taxable investment until retirement without ever realizing any of the inherent gain. For example, assume that you had a taxable investment on the same assumptions as for the Roth, and the investment return is taxed currently in each year. In that case, the taxable investment will have a value of $7,507.38 at retirement, none of which will be taxed on withdrawal because it has all been taxed on a current basis. The Roth therefore provides an additional $1,550.69 in future benefit over the taxable investment. Of course, if the taxable investment generates only long-term capital gains, and those gains are realized less frequently than every year, the taxable investment provides better future benefits, and if held to maturity at 30 years, provides a future benefit of $10,372.66, which is better than the Roth, but not quite as good as the traditional IRA. It would seem then, that generally speaking, absent unusual circumstances, the traditional IRA is the "right" answer in almost every case.

Change some of your assumptive variables and then see the differences.

1. A future marginal tax rate that is higher than current will tip the scales towards Roth. A lower future marginal tax rate will favor traditional IRAs.
2. We have no way of knowing what the tax schedule will be in the distant future. As a result, many people diversify tax scenarios as well as investment holdings.
3. The roth IRA rules have changed to allow "easier access" to the contributions. Your sons can take out the money you contribute on their behalf any time they like, without penalty. This may be bad (careless spending) or good (no penalty in an emergency situation). Earnings and conversion dollars are a bit trickier to get their hands on. All-in-all you are correct that unknown variables prevent you from having a definitive answer of "which vehicle is better." Consider using both vehicles to hedge the risk.

Victor Roberts wrote:

Your math is correct, but your analysis only applies if all of the money that you have to invest is going into an IRA. If you are keeping money outside of an IRA (and if those funds are available to pay the taxes on the amount invested in the Roth IRA), then the Roth IRA comes out ahead. Let's modify your example a little and say that you have $5,000 that you are going to invest and that the maximum IRA contribution is $3,000. I'll use the same 20% tax bracket and 5% growth rate (compunded monthly) that you did. With a regular IRA, you put $3,000 into the IRA (free of tax) and the other $2,000 goes into an outside investment. The $2,000 is subject to $400 of tax, leaving $1,600 to be invested. The $3,000 in the IRA grows to $13,403.23, as you indicated, but you have to pay tax on the withdrawal of $2,680.65, leaving $10,722.59. The $1,600 in the taxable account grows by 5% compounded monthly each year, and each year that growth is taxed at 20%. Over 30 years this account will grow to $5,330.40. The total amount, after taxes, at the end of the 30 years is therefore $16,052.99. Now, if we use a Roth IRA instead of a traditional IRA, you put $3,000 into the IRA, and the other $2,000 goes into an outside investment. The entire $5,000 is subject to $1,000 of tax, leaving $1,000 to be invested. The $3,000 in the Roth IRA grows to $13,403.23, which can all be withdrawn free of tax. The $1,000 in the taxable account grows by 5% compounded monthly each year, and each year that growth is taxed at 20%. Over 30 years this account will grow to $3,331.50. The total amount, after taxes, at the end of the

--Chris

Your math is accurate and I reached the same conclusion. What is missing is what you try to hold fixed, the marginal tax rate. That rate isn't level through one's life. The under saver may drop from 28% to 15% at retirement and the over saver may find they've saved their way to a higher tax bracket. Keep in mind, the standard IRA has required distributions which may force one right into the next bracket. I advise an 80 year old who is about $5000 under the 25% bracket, so for the past few years we convert the right amount to stay right in the 15%. This slows down the growing RMDs, and in 10 years, she'll have $100,000 that won't be subject to the higher rate. Advising a younger person, I'd advise them to go Roth while in the 15% bracket, but when 28% to lean toward the tax deductible accounts, 401(k) or IRA. Just a general comment on that. JOE

Huh? Really? That's completely counter to my understanding of the Roth IRA! If that were the case, there'd be little point to converting a conventional IRA to a Roth IRA. My understanding was that qualified withdrawals from a Roth IRA are completely tax free. The Motley Fool website

Are you sure about this? The IRS states that qualified distributions of INCOME from a Roth IRA are tax free. Qualified distributions include normal distributions after the tax payer reaches 59 1/2 years of age.

-- Vic Roberts Replace xxx with vdr in e-mail address.

Not true. Qualified withdrawals are also tax-free. Withdrawals are qualified as long as you're 59.5 years old or disabled, and the account has been open at least 5 years.

-- Barry Margolin, snipped-for-privacy@alum.mit.edu Arlington, MA

This is wrong. Qualified distributions from Roths are totally tax-free. See IRS Publication 590.

-- Phil Marti Clarksburg, MD

Huh? Once someone has had any Roth IRA open for at least five years *and* is over age 59.5 (or is under but meets some exceptions), withdrawals from a Roth IRA *are* completely tax-free. I didn't see anything in the original poster's email that indicated a plan to withdraw funds prior to age 59.5.

-- Rich Carreiro snipped-for-privacy@animato.arlington.ma.us

Ooops!

_All_ _Qualified Distributions_ from a Roth IRA are tax-free, under current law. I realize that while there is a certainty about the very existence of *death and taxes* ... there can be no equal certainty that the Congress will not (in its infinite "wisdom") change tax laws in the future, and retract the tax-free distinction currently available under the Roth IRA rules ... however, there is no doubt that you have mis-stated the current law. I believe you were thinking of distributions taken either during the first five years after establishment of a Roth IRA, or before the age of 59 1/2 -- since both of these actions would limit the "tax-free" withdrawal to the amount of original contributions. But Pub 590 leaves no doubt that if the distribution is _Qualified_ -- that is, taken after age 59 1/2 and more than five years after inception for the Roth IRA in question -- then said distribution is "qualified" and is not subject to tax or penalty. [See Figure 2-1, under the heading "Are Distributions Taxable" in the section on Roth IRAs.] Bill