Roth vs Traditional: A Comprehensive Comparison

For the technically minded folk, here’s a full comparison of Traditional and Roth accounts. This builds off the post from last week where I discussed the main tax differences with Roth and Traditional accounts at a high level – see Roth vs Traditional: A Simplified Approach. This was an accurate comparison but it ignored several additional aspects worth considering when weighing this option. Let’s dive in.!

Income Taxes: Contributions to Traditional accounts are deductible from your income and future distributions are taxable. Alternatively, contributions to Roth accounts are not deductible from your income and future distributions are non-taxable. The Federal government progressively taxes income with 7 different tax brackets. States tax income in various ways. Most states progressively tax income but some institute a flat tax and others don’t tax income altogether. A detailed article on taxation is in the works, so keep posted for this.

Let’s briefly revisit the example provided in the last post. Imagine a 25-year-old contributing $500 monthly to a retirement account for the next 40 years. Over this time, they would have contributed $240,000. Assuming a 7% average rate of return the value of this account would grow to about $1,200,000. The same would be true for the IRA and Roth. The most common consideration when weighing the differences of these two account types is to compare your current tax bracket to your expected future tax bracket. There is some merit in this consideration but it largely ignores the breakdown between contributions and investment growth. You can choose to receive $240,000 of tax deductions during your working years and in turn have a $1,200,000 pile of taxable money or you can choose to pay tax on $240,000 during your working years and have a $1,200,000 pile of non-taxable money.

Everyone’s tax situation is different so imagine this 25-year-old is square in the 22% federal bracket. Because contributions to Roth accounts aren’t deductible from income, they would have paid 22% federal income tax on their $240,000 contributions, or $52,800. This seems like a large amount of tax and it doesn’t even account for state taxes. Because state taxes vary, we won’t address them but this exclusion won’t change the conclusion.

$52,800 in taxes is a large sum of money but it only represents about 4.4% of the $1,200,000 account value 40 years from now. In retirement, people typically make systematic withdrawals from their retirement accounts for the remainder of their lifetime. If these distributions were coming from a Traditional account and were taxable, they would be spread out over three or four decades. There’s a high likelihood the effective tax on future systematic distributions would be greater than 4.4%. Keep in mind that after 40 years when there are no longer contributions being made to this account it’s value should continue to grow, compounding this tax difference.

One Step Further: This is a fair comparison but it doesn’t tell the whole story. Roth accounts seem to be the shining star in the above calculation but let’s take this one step further before drawing any conclusion. If the 25-year-old in this example opted for the Traditional account, their federal income tax would be about $1,320 less each year contributions were made. If these tax savings were invested similarly, earning 7% average annual growth, they would grow to about $265,000, increasing the future value of your investments by 22% (imagine that!). An employer sponsored plan can accept more than $6,000 annual contributions but an IRA for people 49 and younger cannot. If this money were deposited into a non-qualified account the investments growth would likely be taxed through the years and net less than $265,000. Invested with tax efficiency in mind this could be a modest impact, but to understand this complicates the scenario beyond the scope of this article.

On a stand-alone basis and exclusively considering future account values, the benefit of Roth accounts can be largely made up for by reinvesting the tax savings provided by Traditional accounts. When considering how these accounts will play into your overall plan, however, there’s more to consider. Roth and Traditional accounts are tools. How and why you utilize these tools constitutes a plan. Let’s take a look at some planning considerations pertaining to these tools. Keep in mind some of these considerations pertain to contributions as well as distributions. It’s important to keep the end result in mind so the remainder of this post will address considerations of both.

Survivorship Income and Taxes: Income limits on tax brackets are higher for those married and filing joint returns than those who are single. In fact, the difference is two-fold. To clarify this, the first federal income bracket for 2019 is 10% for incomes of single individuals up to $9,700 and up to $19,400 for married couples filing jointly. Your bracket influences the tax rate you pay on income and affects the rate you pay on capital gains. The standard deduction is also worthwhile addressing. Whether you’re single or married, rich or poor, there’s an amount of income that is not taxable, called deductions. The majority of people claim the standard deduction, which is $12,200 for singles and $24,400 for married couples.

After the first death, the surviving spouse will almost always lose income. Additionally, the survivor will lose $12,200 in deductions if they claim the standard amount. Let’s assume the surviving spouse’ income is reduced to 80% of what it previously was because the lower of the two social security incomes was lost. You don’t have to stretch your imagination too far to realize the tax consequences of the combination of 80% survivorship income accompanied by tax brackets and standard deductions that are reduced to half what they previously were. What this can translate to is less income and higher taxes for the survivor – a one, two, punch.

Tax Control: When you defer taxes with a Traditional account you’re surrendering some future control of the taxation of these assets. The timing of future distributions as well as the tax rate applied to these distributions are both partially controlled by the government. Beginning the year you turn age 72 you’re required to begin taking annual withdrawals from these accounts, even if you don’t need the income. These distributions are appropriately called required minimum distributions (RMD). The tax rate on these distributions will depend on the bracket you find yourself in during retirement but there’s no certainty how these brackets will be structured in the distant future.

With Roth accounts, you maintain control over taxes. You’ve already paid the tax bill on Roth accounts and there is no question what the net value is. $1,200,000 is worth $1,200,000, and not some unknown amount net of some unknown tax rate. Roth accounts also avoid required minimum distributions and future distributions you make will not be considered income (as long as you follow the rules.)

Also, worth your consideration is how likely it is that our country will experience higher overall future taxes. The likelihood of this is up for debate but I fear the likelihood is high. Should this occur, I’m of the belief the middle class will not be excluded from the affects.

Qualified Charitable Distributions (QCD): The only way for tax deferred retirement account distributions to be considered non-taxable is to donate them to charity. This is an appealing way to donate surplus retirement funds. After age 72, the government will impose RMDs and people with tax deferred retirement assets will be required to make distributions from their accounts. It’s common practice for people with charitable intent to donate retirement distributions to charity to avoid taxes. This is considered a non-taxable event since charities don’t pay tax on this distribution.

Inherited IRA Rules:  When someone with a retirement account dies, this passes to their beneficiaries as an inherited account. Owners of inherited retirement accounts are still subject to RMDs. If the owner is a spouse, the RMD schedule will be based off their own distribution period.

For non-spouse beneficiaries, there’s a couple additional considerations. If the original owner was subject to RMDs prior to passing, the inherited owner will be subject to RMDs based off the beneficiary’s distribution period. If, however, the original owner died before the RMD beginning date, the non-spouse inherited owner will be required to liquidate the account within 10 years. Having to liquidate this in a short period of time could result in significant tax liabilities.

The second special consideration applies to Roth accounts. These accounts aren’t subject to RMDs unless they become inherited by a non-spouse beneficiary. Fortunately, distributions from Roth accounts most likely won’t be taxable.

Controlling Taxable Income: Social Security is a taxable income but the taxable amount depends on other income sources. Likewise, Medicare premiums and social programs such as medical assistance, state run health insurance and tax credits are often means-tested and based on your adjusted gross income (AGI) or modified adjusted gross income (MAGI). Contributions to Traditional accounts are considered above the line and can reduce your AGI & MAGI, making you eligible for these benefits. Likewise, future distributions from Traditional accounts can increase AGI & MAGI.

Special Situations: If you find yourself in a situation with temporary high income and expect this to be lower in the near future it could be beneficial to reduce income with contributions to IRAs and convert these at lower rates in the future. The most significant difference in federal income tax rates is from 12% to 22%, and from 24% to 32%. It might make sense to capture the difference in these by contributing to a Traditional account and converting these contributions to Roth when your tax bracket is lower. A conversion of these funds will create a taxable event and if the stars align it could be considered an arbitrage opportunity.

Conclusion: It’s easy to get bogged down when weighing all the considerations discussed here. The key takeaway is that a generic statement about one type of IRA being better than the other is not accurate or responsible. The matter of fact is it depends on your situation and your priorities, which can change throughout life. The reality is that a diversified approach to Traditional and Roth could be the best approach by allowing you to benefit from aspects of both account types. Also, if you contribute to a Traditional account you have the option to convert this into a Roth account in the future. This flexibility could become a part of your overall plan, but also adds to the complexity of this discussion and will be address in a stand-alone post in the near future.

My intent is not to inundate you with information without helping weigh these considerations. I want this information to be helpful and applicable to real life so allow me to provide some generalities:

Young people: The longer your money will be invested, the more appealing Roth becomes. Try making initial contributions in your early career to Roth. The exception to this is if you find yourself in a very high tax bracket, or are attempting to reduce AGI.

Single people with no expectation of ever being married have fewer reasons to consider Roth, but other aspects such as tax control could still be beneficial.

Charitably inclined people who plan to have excess assets should take advantage of deductible contributions to Traditional accounts and utilize qualified charitable distributions to avoid future tax on distributions. This is a rule that could change in the future.

If you are far enough along in life to know you’ll have a survivorship concern, the survivor will be less crippled by owning Roth assets. The financial effect of losing a spouse varies greatly and needs to be determined on a case by case basis but it certainly crosses my mind when considering my wife. This likely isn’t an exclusive reason to show favoritism to Roth accounts unless there is a known health issue.

If early retirement is in your future it’s likely you’re in a high tax bracket during your working years, live well within your means, and are making maximum contributions to retirement accounts. If this is true it could present a future window of opportunity for conversions from Traditional to Roth prior to receiving social security or RMDs. You will be taxed on money that’s converted, which could be at a lower bracket in the early retirement years.

Gifting to another person: If you plan to have excess retirement assets and gifting to another person is front of mind you should consider how your tax situation compares to your beneficiary’s tax situation. If they are younger and expected to inherit this while at the peak of their career it could make sense for the original owner to pay tax, as opposed to the inherited owner.