This subject has been covered extensively by other personal finance bloggers and authors; the purpose of this post is to provide links to articles covering the basic concepts, and a simple tool for comparing taxable, tax-free Roth and tax-deferred traditional IRA and 401 (k) accounts.
Investopedia author Rich White explains the tax neutrality of traditional vs Roth IRAs in The Simple Tax Math Of Roth Conversions, and Bad Money Advice provides the algebra proving neutrality in Why are Roth IRAs so Confusing?
In Roth Mania!, JoeTaxpayer wants you to carefully consider your future marginal tax rate before jumping on the 2010 Roth conversion bandwagon. Likewise, Mike Piper gives you some reasons why it might not make sense to convert in Should I Convert my Traditional IRA to a Roth IRA
Still, it can be advantageous to contribute or convert to a Roth, for example if you
- believe your tax rate will be higher in the future,
- you’ve already taken advantage of your employer’s 401(k) match contributions,
- you want to increase your tax diversification, or
- you want to transfer assets to a Roth to minimize inheritance tax for your children or an unmarried partner.
In Tax Diversification: Roth IRA vs. Traditional IRA, Mike Piper explains what tax diversification is and how to tax diversify.
If you’re interested in Roth inheritance benefits, check out Estate Preservation: Using the Roth IRA. In the upcoming Financial Organizing Soap Opera Episode #4: Owner-Builder, Jack’s sister Sarah wants to talk to Holly about a Roth conversion in for estate planning reasons, to protect her significant other Julie from excessive taxes in the event of her death.
Now for the tool. deferral.xls is a simple spreadsheet you can use to figure out the maximum tax rate at distribution above which there is no benefit to tax deferral for a given set of defined parameters. If you believe your future tax rate will be higher than this rate, there’s no benefit to tax deferral. A tax-free Roth makes sense in this case, but it also makes sense if you believe your future tax rate will be higher than your current tax rate.
The math behind the formula in deferral.xls is explained in deferral.pdf.
I welcome corrections/revisions if anything looks wrong or needs clarifying!
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I was just beginning to look into a Roth IRA for investment planning. I’ll have to check out your two articles and see if it still makes sense for me to do so.
thanks for the additional info!
Maybe you can correct some confusion that I have with regard to the benefits of a Roth IRA. I understand the discussion of your tax rate with regard to funds that you are contributing to the Roth. Since in a regular IRA, you pay pre-tax dollars, up to a certain income limit, it makes sense to instead put them into a Roth if you believe that your Tax rate will be higher when you retire, thus saving you money on taxes by paying them up-front.
Where I am confused about the discussion is with regard to the earnings from a Roth. I would think that earnings would eventually make up the largest portion of the funds inside the Roth. Since they are tax-free if you leave money in the Roth for at least 5 years, doesn’t this automatically make it a better deal than any tax-deferred plan? I would think that regardless of your marginal tax rate, zero taxes on earnings is going to be a lower rate. Am I correct in this thinking, and if not, what am I missing?
Thanks!
Hi Russell,
No, the tax-free earnings don’t automatically make the Roth a better deal.
Suppose PV is the present value of your savings, you put it in a traditional IRA and it grows for n years tax free at compounded interest i until withdrawal, at which point it’s taxed at Tn, the tax rate at withdrawal. Here’s what you get:
[(PV)(i)](1 – Tn) = (PV)(i) – (PV)(i)(Tn)
For example, if you invest $1 at 7% compounded annually for 20 years, that grows tax free to $3.87. Let’s say your tax rate Tn at withdrawal is 30%. So you get to keep $3.87(1 – .30) = $2.71.
In the case of the Roth you get:
[(PV)(1 – T0)](i) = [(PV) – (PV)(T0)](i) =
(PV)(i) – (PV)(i)(T0)
For example, let’s say you have $1 to invest, and the current tax rate T0 is 30%. Since you pay the tax up front, $1(1 – .30) = $0.70, you’re investing a smaller amount. Suppose this $0.70 grows tax free at 7% compounded annually for 20 years. You get $2.71, same as with the traditional IRA.
However, if the future tax rate Tn is higher than the current tax rate T0, the Roth will generate a higher return.
Hi Susan,
Thanks for the nice compliment over on my guest article at LenPenzo.com! (http://lenpenzo.com/blog/id824-23-creative-and-sure-fire-ways-to-easily-earn-extra-money.html)
This is very cool that you have provided this Excel sheet for download! Have you considered maybe turning it into an online tool that people can use right on your website?
Hi Joel, thank you, and yes, I have thought of this, just haven’t had time to work on it.