Roth vs. Traditional IRA – What Hath Roth Wrought

By Aubrey L. "Al" Baker, CFP®Blog

The Roth IRA /401( k) versus the Traditional IRA/401 (k) or What Hath Roth Wrought?

I have read articles in a number of financial periodicals, authored by financial advisors and planners for whom I have a lot of respect, but with whom I disagree when it comes to a decision between a traditional IRA  and a Roth IRA .
The point on which I disagree is the assumption that the individual’s marginal tax rate may be lower during retirement and consequently he or she will have reduced taxes when withdrawing from their IRA.  This may be true, but it is still tax on the growth of the IRA.  My argument is that it is far better to pay the taxes up front, before the underlying investments grow, then paying taxes on the original investment and the growth.
Although the Individual Retirement Arrangement (IRA) can trace its roots to the Employee Retirement Security Act (ERISA) passed by Congress in 1974, it didn’t provide for an  Individual Retirement Account (IRA) until 1981.  It is continuing to evolve, although Congress sometimes seems to take two steps forward and one step backward.
Originally, in 1981 with the passage of the Economic Recovery Tax Act (ERTA), a wage earner could invest up to $2,000 annually, all of which was tax deductible, however the contribution and all growth was taxable upon withdrawal at the current personal income tax rate.  If you invested $2,000 annually for 20 years and your $40,000 investment grew to $125,000, taxes would be due at your personal income tax rate on every dollar you withdrew.
Congress took a step backward in 1986 when limits were placed on incomes, although contributions of up to $2,000 annually were allowed, the contributions were not always tax deductible, but the growth was still taxable, so in the example above, taxes would be due on the $85,000 growth as money was withdrawn.
The $2,000 limit remained for far too long, but has increased to its current maximum of $5,500 with a provision of an additional contribution of $1,000 annually if you are 50 or older.  There are still income limits that are dependent on whether or not you have an employer retirement plan available. The income limits are relatively reasonable and do increase periodically.
Congress took a giant step forward in 1998 when it passed the Roth IRA sponsored by Senator William Roth from Delaware. Senator Roth was also a co-author of the Economic Recovery Tax Act of 1981 with Representative Jack Kemp.  The act was known as the Kemp-Roth Tax Act.
The Roth IRA allows you to invest the same amounts as the traditional IRA except that the money invested is after tax; income taxes have been paid.  The real advantage is that the growth is not taxed.  Using the example of investing $2,000 annually for 20 years where the investment grew to $125,000, taxes would have been paid on the $40,000 invested but the $85,000 growth would not be taxed on withdrawal.  Using the current limit of $5,500 per year for 20 years, your total investment would be $110,000.  If your investment grew to $350,000, there would be no taxes on the $240,000 growth.
The advantage of the Roth IRA over the Traditional IRA is shown in the two illustrations.  In the first, our worker decides at age 32 that it is time to begin saving for retirement and sets aside the maximum every month ($458.33 per month = $5,500 per year).  Our worker is a moderate risk investor and selects a mix of mutual funds that provide an annual return of 8.5%. Upon retirement our worker continues to invest for growth but also wants to reduce risk and accepts a return of 4.25% annually.
The advantage becomes obvious when taxes are compared.  Using the illustration, the worker invests $5,500 a year for 35 years.  If our worker invests in a traditional IRA, no taxes will be paid on the total of $192,500 invested. At a tax rate of 20% our worker saves $38,500 as the fund accumulates and grows. But, as money is withdrawn, taxes are due on every dollar.  As the savings and growth are withdrawn, $13,200 in taxes are paid every year.  Over 35 years the total in taxes paid is $462,000.
If our worker invests in a Roth IRA instead, using the same numbers, taxes of $1,100 are paid annually for a total over 35 years of $38,500.  But, no taxes are due on withdrawals. Again using the numbers from our traditional IRA, total savings over 35 years of withdrawals are $423,500.
Another giant step occurred in 2006  when the Roth 401(k) became available.  A Roth  401 (k ) provides many of the same advantages of the traditional 401(k) in that it is established by an employer to facilitate retirement planning by employees.

Roth vs. Traditional IRA. What Hath Roth Wrought

The Roth IRA /401( k) versus the Traditional IRA/401 (k) or What Hath Roth Wrought?

I have read articles in a number of financial periodicals, authored by financial advisors and planners for whom I have a lot of respect, but with whom I disagree when it comes to a decision between a traditional IRA  and a Roth IRA .
The point on which I disagree is the assumption that the individual’s marginal tax rate may be lower during retirement and consequently he or she will have reduced taxes when withdrawing from their IRA.  This may be true, but it is still tax on the growth of the IRA.  My argument is that it is far better to pay the taxes up front, before the underlying investments grow, then paying taxes on the original investment and the growth.
Although the Individual Retirement Arrangement (IRA) can trace its roots to the Employee Retirement Security Act (ERISA) passed by Congress in 1974, it didn’t provide for an  Individual Retirement Account (IRA) until 1981.  It is continuing to evolve, although Congress sometimes seems to take two steps forward and one step backward.
Originally, in 1981 with the passage of the Economic Recovery Tax Act (ERTA), a wage earner could invest up to $2,000 annually, all of which was tax deductible, however the contribution and all growth was taxable upon withdrawal at the current personal income tax rate.  If you invested $2,000 annually for 20 years and your $40,000 investment grew to $125,000, taxes would be due at your personal income tax rate on every dollar you withdrew.
Congress took a step backward in 1986 when limits were placed on incomes, although contributions of up to $2,000 annually were allowed, the contributions were not always tax deductible, but the growth was still taxable, so in the example above, taxes would be due on the $85,000 growth as money was withdrawn.
The $2,000 limit remained for far too long, but has increased to its current maximum of $5,500 with a provision of an additional contribution of $1,000 annually if you are 50 or older.  There are still income limits that are dependent on whether or not you have an employer retirement plan available. The income limits are relatively reasonable and do increase periodically.
Congress took a giant step forward in 1998 when it passed the Roth IRA sponsored by Senator William Roth from Delaware. Senator Roth was also a co-author of the Economic Recovery Tax Act of 1981 with Representative Jack Kemp.  The act was known as the Kemp-Roth Tax Act.
The Roth IRA allows you to invest the same amounts as the traditional IRA except that the money invested is after tax; income taxes have been paid.  The real advantage is that the growth is not taxed.  Using the example of investing $2,000 annually for 20 years where the investment grew to $125,000, taxes would have been paid on the $40,000 invested but the $85,000 growth would not be taxed on withdrawal.  Using the current limit of $5,500 per year for 20 years, your total investment would be $110,000.  If your investment grew to $350,000, there would be no taxes on the $240,000 growth.
The advantage of the Roth IRA over the Traditional IRA is shown in the two illustrations.  In the first, our worker decides at age 32 that it is time to begin saving for retirement and sets aside the maximum every month ($458.33 per month = $5,500 per year).  Our worker is a moderate risk investor and selects a mix of mutual funds that provide an annual return of 8.5%. Upon retirement our worker continues to invest for growth but also wants to reduce risk and accepts a return of 4.25% annually.
The advantage becomes obvious when taxes are compared.  Using the illustration, the worker invests $5,500 a year for 35 years.  If our worker invests in a traditional IRA, no taxes will be paid on the total of $192,500 invested. At a tax rate of 20% our worker saves $38,500 as the fund accumulates and grows. But, as money is withdrawn, taxes are due on every dollar.  As the savings and growth are withdrawn, $13,200 in taxes are paid every year.  Over 35 years the total in taxes paid is $462,000.
If our worker invests in a Roth IRA instead, using the same numbers, taxes of $1,100 are paid annually for a total over 35 years of $38,500.  But, no taxes are due on withdrawals. Again using the numbers from our traditional IRA, total savings over 35 years of withdrawals are $423,500.
Another giant step occurred in 2006  when the Roth 401(k) became available.  A Roth  401 (k ) provides many of the same advantages of the traditional 401(k) in that it is established by an employer to facilitate retirement planning by employees.

 

 

Traditional IRA

 

Roth IRA