Traditional IRA or Roth IRA?
There are so many unknowns that it is impossible to make an informed decision on which type of IRA to use as your retirement vehicle even though it is a decision that will have implications for the rest of your life.
The variables are these:
- Your income over all your employed years.
- The income tax rates while employed.
- Income tax rates during retirement.
- Income tax policy all through your life.
- How many years you will work.
- Amount you will need in retirement.
- Rate of inflation.
- How many years you will live in retirement.
- Income during retirement.
- What kind of lifestyle you will want once retired.
All of the above will influence the IRA decision. Since none of the values can be known at age 35, the IRA decision cannot be made in a definitive manner.
A Simulation Says Traditional IRA is Best
The above none withstanding, we have run a simulation using a few of the above variables and ignoring the rest. The results, shown below, used these variables and values.
- Annual Income (stays constant for all working years): $70,000
- Percent of Working Annual Income to maintain desired lifestyle: 70%
- Effective Income Tax Rate* while employed: 15%
- Effective Income Tax Rate after retirement: 15%
- Annualized Rate of Return on Investments for entire period (50 years) under consideration: 12% (DJIA has achieved this over the period 1966 – 2016)
- $4800 a year ($400 month) to invest, assumed to be invested at beginning of year:
Traditional: all $4800 goes into the market,
Roth: Assuming 15% Effective Tax Rate, only $4080 actually goes into market,
$720 goes into axes.
OR… looking at it from the outside in…
If you say “I will invest $4080 into the market”, you had to earn $4800 in order to have $4080 net of taxes. With the traditional IRA, you can put the entire $4800 into the market.
The table below shows just the first three and the last three years of investing. The entire table can be seen by clicking HERE. The simulation shows that using a traditional IRA is significantly better than the Roth IRA.
|Year||Invest Trad IRA||Invest Roth IRA||EOY Trad Value||EOY Roth Value|
During the 30 year accumulation period, the Traditional IRA can have more money at work in the market because the money is not taxed. This additional amount, $720 each year, gets compounded by the market, leading to a portfolio that is $173,000 more than the Roth IRA portfolio.
Now the shoe is on the other foot. In the withdrawal phase the Traditional IRA holder will have to withdraw more each year than will the Roth IRA holder because the withdrawal is taxed.
|Year||Need In Pocket||Begin of Year Trad Portfolio Value||Begin of Year Roth Portfolio Value||Trad Withdrawal @ Beginning Of Year,||Roth Withdrawal @ Beginning of Year||EOY Trad Portfolio Value||EOY Roth Portolio Value|
Click HERE to see the entire simulation, years 1 – 50.
Because the Traditional IRA started with more money than did the ROTH, the Traditional IRA increases in value faster than does the Roth IRA, even though each withdrawal from the Traditional IRA is larger (have to pay taxes on withdrawal) than is the withdrawal from the Roth IRA.
It appears that under the assumptions about the future, as documented above, the Traditional IRA is a better investment vehicle than is the Roth.
Alternative, Non Quantitative Analysis
A bird in the hand is worth two in the bush.
Meaning… you can make a tax free investment NOW, who knows what the situation will be when (and if) you are retired. Stick with the traditional IRA.
*Effective Income Tax Rate
The percentage of Total income paid in taxes after taking all deductions (dependents, deductions, credits, etc). Much lower than the marginal tax rate most people think of. The effective tax rate for persons earning less than $150,000 is no more than 15%.