The Superior Retirement Account – Will that be Traditional or Roth?

Posted on May 19, 2014 by Dr. Marcinko

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Weighing the Costs

Lon Jeffries[By Lon Jefferies MBA CFP®]

As an informed investor and reader of this ME-P, you’re likely familiar with the difference between a traditional IRA/401(k) and a Roth IRA/401(k).

While the traditional account enables you to postpone taxes on both the income invested and its growth until the funds are withdrawn, a Roth account does not provide an initial tax benefit but investment growth is tax free. So which is better?

Let’s answer the question with some simple math. Suppose an investor in the 25 percent federal tax bracket invests $1,000 of pre-tax income, obtains an 8 percent annual return over the next 10 years, and is still in the 25 percent tax bracket in the future. Would this investor profit more investing in a traditional or a Roth account?

As the chart below illustrates, the investor in this scenario would end up with the exact same amount in either a traditional or a Roth account.

So does the decision to invest in a traditional or Roth retirement account not matter? Not so fast.

Constant Tax Rate
Traditional Roth
Initial Tax Bill (25%) $0 $250
Invested Amount (after-tax) $1,000 $750
Future Investment Value $2,159 $1,619
Future Tax Bill (25%) $540 $0
After-Tax Value in 10 Years $1,619 $1,619

Lower Tax Bracket in Future

Let’s assume our investor will have a reduced income when she retires in 10 years, causing her to be in the 15 percent tax bracket in the future. Perhaps the worker is in her prime earning years and will have less income during retirement. In this scenario, due to the up-front 25 percent tax bill, investing the funds in a Roth would lead to the same after-tax value of $1,619. But investing the funds in a traditional account would allow the full $1,000 to experience growth for 10 years, with a reduced future tax bill of 15 percent, leaving $1,835 of after-tax value in the account. This investor would benefit from delaying taxes into the future when she would be in a lower tax bracket.

Lower Tax Rate in the Future
Traditional Roth
Initial Tax Bill (25%) $0 $250
Invested Amount (after-tax) $1,000 $750
Future Investment Value $2,159 $1,619
Future Tax Bill (15%) $324 $0
After-Tax Value in 10 Years

$1,835

$1,619

Higher Tax Bracket in Future

On the other hand, if the investor was in the 15 percent tax bracket this year but expected to be in the 25 percent bracket during retirement (potentially a young employee expecting his earnings to rise), paying taxes now at 15 percent would allow $850 to be invested, which after 10 years of 8 percent growth would be worth $1,835 tax free.

Higher Tax Rate in the Future
Traditional Roth
Initial Tax Bill (15%) $0 $150
Invested Amount (after-tax) $1,000 $850
Future Investment Value $2,159 $1,835
Future Tax Bill (25%) $540 $0
After-Tax Value in 10 Years $1,619 $1,835

Roth Advantages

What if you expect to pay a comparable tax rate both now and in the future? A Roth account offers several advantages in this scenario.

First, as taxes have already been paid on a Roth account, the government doesn’t require investors to take required minimum distributions (RMDs) from these accounts, whereas RMDs are required from traditional retirement accounts beginning at age 70½. Without RMDs, Roth accounts can grow tax free for the investor’s entire lifespan.

Additionally, upon death, Roth accounts pass to an investor’s heirs without any tax liability, while those who inherit a traditional retirement account must pay taxes on the assets.

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IRA

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Second, money withdrawn from a traditional retirement account before the investor is 59½ may be subject to a 10 percent penalty. Yet contributed funds to a Roth account (but not the growth on the contributed funds) can be withdrawn at any time without penalty. While withdrawing funds before retirement isn’t advisable, the added liquidity of the Roth account can prove useful in emergencies.

Finally, even if your income is expected to remain constant, investing in a Roth account allows you to lock in your taxes at today’s rate as opposed to taking the risk that national tax rates might be raised in the future.

If you’re unsure how your future tax bracket will compare to your current rate, diversify. Nothing prevents you from having both a traditional and a Roth retirement account. This not only allows you to hedge your bets, but puts you in a position during retirement to take distributions from your tax-deferred account in low-income years and from the tax-free account in years when you are in a high tax bracket.

Assessment

http://www.utahbusiness.com/articles/view/weighing_the_costs/?pg=1

Conclusion

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