7 case studies: Roth IRA or traditional IRA? Roth wins out most of time

Should you contribute to a Roth IRA or a traditional IRA? You may be surprised to learn that the Roth IRA beats the traditional IRA almost all the time. Let’s look at seven common scenarios. In all these examples, we’ve assumed you would leave an initial contribution in the Roth or regular IRA for a number of years and then pull out the money as a lump sum in retirement after age 591/2. For simplicity’s sake, we’ll assume a 10 percent before-tax rate of return for each example.

Case study 1: 30 years to retirement; 28 percent tax rate in all years.

Compare a $4,000 nondeductible contribution to a Roth IRA to a $4,000 deductible IRA contribution. You’ll pay no tax on the dollars pulled out of the Roth IRA, while withdrawals from the regular IRA are 100 percent taxable.

To make sure we’re comparing apples to apples, we also invest the $1,120 of tax savings from the deductible IRA contribution ($4,000 times 28 percent) for 30 years at an after-tax return of 7.2 percent (10 percent less 2.8 percent taxes).

In the end, you’d end up with $69,798 in the Roth IRA, all of which can be pulled out tax-free. The same amount is in the regular IRA, but after paying the 28 percent tax, you actually keep only $50,254. With the deductible IRA account, you also collect an additional $9,017 from the $1,120 of tax savings invested at 7.2 percent over 30 years.

The grand total for the regular IRA is $59,271, but that’s still $10,527 short of the Roth IRA nest egg.

Case study 2: 20 years to retirement; 28 percent tax rate in all years.

With the same $4,000 in assumed contributions, the Roth IRA still wins the race by over $3,000. You end up with $26,910 in the Roth account versus $23,874 with a traditional IRA.

Case study 3: 10 years to retirement; 28 percent tax rate in all years.

The Roth account puts you ahead again, although by a slimmer margin. You wind up with $10,375 in the Roth account versus an after-tax amount of only $9,715 with a deductible IRA.

Case study 4: 30 years to retirement; 35 percent tax rate in all years.

The Roth IRA wins again, this time by $69,798 to $54,629. You’ll notice this is a bigger margin than in Case study 1, where a 28 percent rate was assumed.

Raising the assumed tax rate to 33 percent or 35 percent over 30, 20 and 10 years results in bigger advantages for Roth IRAs than what we found in the first three case studies, which all assumed a 28 percent rate. In general, the higher the tax rate, the better Roth IRAs fare as compared to the regular IRA.

Case study 5: 30 years to retirement, 28 percent tax rate in years until retirement; 15 percent rate when the account is liquidated.
 

Even under this assumption, the Roth IRA beats the deductible alternative (barely) by a $69,798 to $68,345 score.
 

The Roth IRA’s advantage is narrowed because we assume a low marginal tax rate—15 percent—will apply when funds are pulled out of the regular IRA. To be taxed at only 15 percent, you must have a relatively modest income in retirement.
 

Case study 6: 20 years to retirement; 28 percent tax rate in years until retirement; 15 percent rate when the account is liquidated.

In this case, the deductible IRA finally wins. However, the margin is small—only $27,373 to $26,910.

In fact, for periods of less than 20 years until retirement, the regular IRA will win in all cases if you assume a 28 percent or higher tax rate in preretirement years and only a 15 percent rate when you retire.

Again, however, a retirement-age tax rate of only 15 percent may be unrealistic for people who have earned big bucks for years and accumulated some wealth along the way.

Case study 7: 20 years to retirement; 15 percent tax rate in all years, including retirement year.

With this set of assumptions, the Roth IRA jumps back out in front, $26,910 to $25,941. This is because the $4,000 contribution to a regular IRA produces only $600 of tax savings in Year 1.