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For the right person, a Roth IRA can be a fantastic retirement savings vehicle over the long term. So much so that it might seem to some that it’s always the right choice, no matter what. After all, tax-free income does sound pretty great. However, like anything in your retirement planning journey, this decision on pre- vs. post-tax contributions will require delving into the nuances of your specific situation.
Do you have questions about planning out your retirement contributions? Speak with a financial advisor today.
The key advantage to a pre-tax traditional IRA is that you can invest more money over the long run. In theory, all the money you save from pre-tax contributions is capital available for further compounding gains.
The key advantage to a Roth IRA is that you save on taxes in retirement, as compared to pre-tax accounts where those taxes are only deferred. With these, you eventually pay income taxes on both contributions and returns. With post-tax accounts like a Roth IRA, you pay no money at all on your returns because you’ve already been taxed on your contributions.
For example, say that you want to invest $1,000 from your paycheck, but pay an effective tax rate of 20%. With a Roth IRA, you would first pay $200 in taxes, then invest the remaining $800. With an IRA, you would save that $200 in taxes and can invest the full $1,000.
Then, let’s say that this account doubles in size and you withdraw it. Your Roth IRA would grow to $1,600 and you would keep all of it. Your IRA would grow to $2,000 and you would pay $400 in taxes, leaving you again with $1,600 after taxes. (Note that this situation is simplified for the purposes of demonstration.)
So, how do you choose? You will usually be better off picking based on when you expect to pay higher tax rates.
More specifically, if during your working years you currently pay more in taxes than you expect to in retirement, then a traditional IRA’s ability to help you wait on taxes and deduct your contributions in the meantime would theoretically be preferable. If you will pay a higher tax rate during retirement, then a Roth IRA’s tax-free withdrawals may work better.
Using our example above, say that you invest $1,000 while working and make 100% in returns by the time you retire. Let’s also assume that while working, you paid 20% in taxes, and then pay 10% when you’re withdrawing in retirement. At retirement, your balances would be at $1,600 in a Roth IRA versus $2,000 in a traditional IRA. But then accounting for taxes, your Roth withdrawal will be worth $1,600 with no taxes, while your traditional IRA withdrawal will be worth $1,800 after subtracting 10% in taxes from your balance. Again, because you’re paying more in taxes while working, a traditional IRA is much more ideal.
