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March 27th, 2009 at 11:16 pm

Elsewhere on the internet, a very interesting discussion is brewing about which account is better, Traditional or Roth? All things being equal, it turns out that the numbers favor the Roth! Color me surprised, and it's not even close!

To delve deeper, first we have to make a few assumptions....

Assumptions
* Assume you have \$100,000 in a traditional IRA (based on the original example).

* Assume the money grows at 8% each year (based on the original example)

* Assume you have \$30,000 in bank savings to cover the Roth conversion if you choose to.

* Assume that the investment horizon is 30 years.

* Assume that the 2009 tax codes do not change between now and 30 years from now. (A big assumption indeed.)

* Assume effective income tax based on filing single in 2009. (I'm cheating here with Money Chimp.)

* Assume the capital gains tax also does not change at 15%.

* Assume that you convert/withdraw all at once, and therefore, pay your taxes in one lump sum (for simplicity sake).

* Assume that's also the only tax you have to pay during those times.

* Assume that there are no legal restrictions of any kind on the Roth conversion.

* Assume that early withdraw penalty is not an issue here either.

Whew! I hope I covered everything. Now let's start with the Roth IRA path.

Roth
1. The cost in taxes to convert the \$100,000 to Roth is \$21,720. That leaves me with \$8,280 in bank savings.

2. The \$8,280 is left to grow in my bank account for 30 years. That's a growth rate of 8% minus capital gains tax of 15% which equals to 6.8% in net growth. 30 years of growth at 6.8% equals to \$59,589.25.

3. The \$100,000 inside the Roth then grows, tax-free, for 30 years, and at 8%, that totals up to \$1,006,265.69.

4. The combined total of the Roth and bank savings gives you a total of \$1,065,854.94.

Ok, let's move on to the Traditional path where you don't convert, and instead, decide to pay the taxes later on.

1. The IRA grows tax-free for 30 years at 8% for the same total of \$1,006,265.69.

2. On the final year, you withdraw it all at once. Money chimp says your tax burden for the entire amount is \$329,877, leaving you with an after-tax total of \$676,388.69.

3. However, you also have \$30,000 left untouched in the bank, growing at a taxed growth rate of 6.8%. After 30 years, that amount is \$215,903.08.

4. That leaves you with a combined total of \$892,291.77.

Conclusion
So, ASSUMING that my assumptions are reasonable and comprehensive enough, and that my math is correct, it's clear then that the Roth would win out. And it's not even close! \$1,065,854.94 and \$892,291.77 is a difference of \$173,563.17! That's a lot of money!

So what happened here? Why such a gap? The basic assumption has always been that people would use the retirement principal to pay for the conversion tax, but a more realistic assumption is to use our own savings instead. And if that's the case, most your money in the Roth path grows tax-free, whereas with the Traditional path, you have much more (in the bank savings) being withered down by paying annual taxes.

Of course, I am making ALL SORTS of assumptions here for simplicity sake and in the interest of attempting a fair comparison, but is hardly representative of real life or our individual financial situations.

And that's why my final answer has always been, "It depends." It's best to just sit down and crunch out the numbers, to see what will work best for you. Still, all things being equal, I thought the numbers would be a lot closer, though I see now that it isn't. Amazing.

### 15 Responses to “Traditional versus Roth”

1. L Saver Says:

Wow! When you see the numbers in black and white, it really shows how the Roth IRA can work for you! Thanks for sharing that.

2. creditcardfree Says:

I've been a big fan of Roth IRA's. I hope to convert some more of our Traditional IRA money, if my husband deploys again...since our taxable income would be zero. The conversion would create some taxable income, but not enough to have to pay taxes! Converting for free is always a good thing!

3. monkeymama Says:

As I have said many times, I think it's a no brainer if you have a 30 year investing horizon. Quite simply, it COMPOUNDS tax free.

My only issue with your analysis is the Traditional IRA would be taxed very highly if it were withdrawn all at once - which isn't exactly a fair comparison. But I think the result would be similar, regardless. ETA: The tax rate looks about what most my retirees pay on their IRA distributions anyway - about 32% between fed and state - so I don't think the tax is necessarily inflated for the one-time distribution.... If you think your tax rate goes down in retirement, think again.

Frankly, for people in a low tax bracket the numbers are more astounding. I get little tax break for my traditional IRA contributions, so it makes the ROTH considerably more lucrative.

4. disneysteve Says:

I'm not surprised at all. I've always thought the Roth was the better deal. Besides, I earn too much to deduct traditional IRA contributions so it is a no-brainer for us.

5. Dave Says:

Sorry, but I see some glaring problems with this analysis.

First, I'm not sure where you are getting a \$21K tax bill on a \$100K one-time Roth conversion. This seems like a very lowball estimate. A single person with \$50K of wages with a \$100K conversion would be well into the 28% tax bracket. Let's ignore state taxes for now, that would leave a tax bill of close to \$30K. Anyone with higher income would have an even higher tax bill.

Second, assuming someone would withdraw the entire amount upon retirement is a bizarre choice. This heavily biases against choosing the traditional, since you would be paying maximum taxes by doing this. A more reasonable assumption is to assume they withdraw 4% a year. Assuming no other income, this would have a huge effect on your taxes.

@monkeymama: If I remember you live in northern California, which is a high cost-of-living area. I would imagine your typical client is heavily skewed towards higher income. For an average household, taking in \$20K in social security and \$40K in IRA withdrawals a year is not going to put them anywhere near 32% tax burden. My parents, retiring this year, will be teetering between 10% and 15% brackets.

6. Broken Arrow Says:

The tax bill is based on an effective tax rate of a person filing single in 2009. It assumes no other income is being made during the time of the withdraw or conversion. Also, yes, state tax is ignored, and that's something that I should have listed in my assumptions.

So yes, there are problems with this analysis in that it is not realistic. But... it was never designed to be realistic. It was only designed to be as simple and as equal to both sides as I can possibly make it.

To that end, I left out as many extraneous factors as I could that would not affect the balance of both sides, so that the end result would also be as easy to read as possible. Earned income is one such example of the things I left out.

Converting or withdrawing all at once is another such example. In real life, I am converting my rollover IRA to Roth in small increments to stay within a tax bracket. Very rarely would we find anyone convert or withdraw an entire lump sum.

However, calculating Roth conversions or traditional IRAs withdraw in small increments was more complicated than I was willing to put forth the time and energy. Also, even if it is much more realistic, for comparison sake, I didn't want introduce an element that would cause calculations on both sides to be fundamentally different.

Still, I confess that of all the things that would bother me the most about this illustration, it would be the part where conversions and withdraw are made all at once.

At the same time, I also hope that people will see that there are simply too many factors being assumed to be realistic to begin with. And that's why I never intended for realism, only to illustrate the (surprising to me) point that, all things equal, the Roth really is better than Traditional.

7. Dave Says:

If you really want all things to be equal, you should tax both the Roth conversion and the full withdrawal of the tIRA at the same tax rate (15% or 25%). Again, not realistic, but a lot fairer than the rates you used (21% for conversion, 33% for withdrawal).

This analysis tells us that for an individual with no income and \$100K in a tIRA, it is better to convert to a Roth now than to pay the maximum taxes possible on the tIRA withdrawals. So for this special case, a Roth is far superior. I think it is overgeneralizing to say "all things equal, the Roth really is better".

8. Broken Arrow Says:

Hmm, well, that's true. I suppose I was trying too hard to factor in effective tax rate when perhaps that made things worse rather than better. Thank you for your input!

9. monkeymama Says:

Dave - most of my working clients have AGI in the \$100k range and are in the 15% tax bracket. This does not take into account all their tax credits, which effectively lowers their rate of tax, sometimes considerably.

Most of my retirees do make about \$40k/year in pension or IRA distributions and \$20k in social security. Literally. They are all in the 25% tax bracket with no other tax credits available. This is why I commented if you think your taxes will go down in retirement, you'd be wrong. I have working clients making \$50k who pay NO TAXES. My one couple who lives solely off social security is still in the 10% tax bracket. I don't have any retirees who pay \$0 taxes. The idea that your taxes go down in retirement, is a myth at best. There are a multitude of reasons for the above results. But this is what I see every day in my line of work.

More to the point, state income taxes are high here too - why my retired clients all pay about 32% - between fed and state. These are pretty average incomes - I don't live in an "expensive" area per se.

Anyway, I personally paid an effective 5% tax on my income in 2008 (both fed and state combined). Dividing my income taxes by my income. My ROTH can grow tax free for 50+ years? I think I will hedge my bets that my taxes will be higher in retirement... & then there are people all over the internet saying people like me ("financial advisors") are so stupid to push the ROTH. Yeah, what do I know. IF I maxed out my Traditional IRAs I would have saved \$500 in taxes this year. BIG WHOOP!!!

10. monkeymama Says:

I just had to add the failing of all these analysis is they fail to realize that the tax code is 10 times more complex than simply "tax bracket."

If most people were literally able to save \$2500 per every \$10k IRA contribution, that would be another story.

You can't have it both ways. If my clients have higher than average incomes as retirees than they must have as workers too. & yet I have very few in the 25% tax bracket even.

11. Broken Arrow Says:

Thank you for the input as well, monkeymama. It always ends up being a good learning experience for me.

Question, this client you mentioned that is making \$50k but is pay no taxes? What exactly is he doing that allows him to do that?

I'll understand if you can't disclose details about him, but in general terms, what can we do to become more tax efficient like that?

12. monkeymama Says:

I paid negative taxes one year I made \$50k. (The government sent me a check - refundable child tax credit).

Married, \$12k mortgage interest, \$5k state taxes (mostly property taxes), \$4k deductible medical/dental expenses (I've mentioned our sky high health insurance - high enough to be partially deductible), deduct \$3500 x 4 for exemptions. Say this leaves \$16k taxable income. Roughly \$2k in taxes (probably over-estimating). Apply \$2k child tax credit (2 kids) and you pay \$0 taxes.

There were 3 years in there we paid about \$0 taxes. Lasr year my fed & state tax bill was a whopping \$4k on about \$80k income.

Funny thing is we contributed to my 401k when we were childless and in a much higher (dual income) tax bracket). We took the big tax break and then converted to a rOTH when our income was very low. This is another example how a conversion could blow a traditional IRA out of the water. PArticularly if you convert in a year like this, with the stock market in the toilet. Wish I had waited a couple of years...

13. monkeymama Says:

P.S. I don't advise taking on massive mortgages, or health insurance premiums, nor having kids, simply for tax breaks.
Most of my retirees are widowed or divorced (this is the reality) and get one exemption and one standard deduction. Usually means a tax deduction of about \$10k-\$15k total, and no tax credits. This leaves them in higher tax brackets pretty rapidly (being single in particular). I don't recommend marriage just for a tax break either.

14. monkeymama Says:

I'm sorry. I just had one more thing to add. I am not of the "ROTH always wins crowd" - not by a mile. But I Want people to at least THINK.

I thought this would be a good example - but it isn't probably. My dad is near retirement, house paid, no deductions or tax credits to speak of, good wage, taxed to oblivion. I would not recommend the ROTH in his case. I realized this is a bad example after I started typing because though he is in a high tax bracket he is ineligible for a deductible IRA contribution. So this year he made a ROTH contribution instead. LOL. Which what it comes down to. But my mom was eligible for the Traditonal IRA and he maxed out his 401k. & I think those were better tax moves in the long haul. The ROTH is just "better than nothing" in his case. My enthusiasm for the ROTH runs thin for those who are much older.

15. Broken Arrow Says:

Hehe, looks like I might have touched on something there? But yeah I don't think I want to get my deductions through huge expenses there.

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