So, you have decided to invest. Great. Presumably, you are investing for a purpose. Even better. If that purpose is for retirement you may have even spent time thinking about whether a Roth IRA or Traditional IRA is best.
For 2017, Roth and Traditional IRA contribution limits both remain at $5,500. The key difference in investing through a Roth IRA or Traditional IRA is the taxation of contributions and deductions.
Contributions to a Traditional IRA are deductible whereas Roth IRA contributions are not. As an example, if you contribute the maximum $5,500 in a Traditional IRA you can deduct that amount from your taxable income. If you are in the 25% federal income tax bracket, that means you would lower your tax bill by $1,375. If that same $5,500 is contributed to a Roth IRA, you still pay income taxes on it.
That may seem like a win for the Traditional IRA but there is a difference on the back end when withdrawals are made that for many, especially younger, investors will far overshadow any upfront tax implications.
That advantage lies with the Roth IRA. Withdrawals from Roth IRA’s are not taxed. Since the money was taxed before it went in, it stands to reason that it should not also be taxed when it is taken out. Of course, this situation is reversed for a traditional IRA. Since the money was not taxed when it went in, it stands to reason that it should be taxed when withdrawn.
So, what? Each dollar is taxed at some point, right? Why does it matter?
Let’s look at an example I have used previously of an investor that is starting when they are 25 and retiring at 65 and compare the differences that would exist between using a Roth or Traditional IRA.
If one were to put $5,500 per year into a Traditional IRA for 40 years they would save $55,000 (40 x $1,375) in taxes if we continue to assume a 25% marginal bracket. This person would have total investments of $1,424,810.85 if we use 8% as an estimated rate of return. Remember though, this final amount is now taxable when withdrawn.
Of course, it won’t all be withdrawn at the same time. A common measure for determining the amount of money that can be withdrawn from a retirement account in each year is the 4% rule. Essentially, you look at the balance of the account and take 4%. In this case, it would be approximately $57,000.
Given the progressive nature of federal income taxes the average tax rate on each dollar withdrawn will be something less than the marginal rate. There are many things that would affect taxation of the withdrawal. I am not a tax professional nor do I want to divert from the main point of this post, so I’ll simply tell you that I am assuming an average tax rate of 12%.
Roth or Traditional IRA?
$57,000 taxed at an average rate of 12% would leave $50,160 in spendable income.
Now, compare that to the Roth IRA. The same numbers apply giving us a withdrawal amount of $57,000. The big difference here is that the full amount is not taxed. That gives the investor an additional $6,840 (the same 12% that would have otherwise gone to taxes) per year in expendable retirement income.